Back on December 11th, I sent an alert to subscribers on the downside risks to the euro, concluding:
The bond markets are already reflecting a two-tier Europe as spreads have soared for Spain, Ireland Greece and Portugal (and to a lesser extent Italy) compared to German Bunds and 'core' Europe. If we get another debt crisis leg, in 2010 or 2011 one policy option will be to allow those countries to devalue within the EMU framework and return to an ERM style system where a new 'Euro-Lite' pegs to the core Euro in a trading band. It would be messy and a last resort, but has been quietly discussed in German policy circles. I'd put the probability at 20-25%, which certainly isn't yet reflected in the euro/dollar exchange rate but will be in 2010; I'd expect to see the euro slide to as low as 1.20 at some point in the next 6-12 mths on such fears.
In fact, I warned of an imminent reversal in the dollar on Seeking Alpha a month earlier, as the bearish consensus had reached a classic sentimant and momentum extreme divorced from objective analysis. I remain very positive and expect the US recovery in 2010 to surprise to the upside, to 3.5-4% real GDP growth. But the biggest surprise in currency markets this year may come from China.
China has been suffering inflationary pressure from loose US monetary policy via the pegged exchange rate, and the country is now taking the steps I've been predicting to tighten domestic policy such as hiking the bank reserve ratio and restricting capital raising in the sectors with the greatest overinvestment, such as cement.
As of yet, interest rates haven't been raised, as has been the case across the region from Australia to India. The problem is that if China raises rates well in advance of the US, it risks attracting further ‘hot money’ capital inflows, exacerbating the asset price risks.
One answer is to revalue the RMB substantially and the issue is whether it takes the form of a gradual or one-off appreciation; circumstances increasingly suggest the latter.
A rise in imported commodity prices in 2010, particularly of food, will likely force the issue (see inflation chart below). Chinese M1 money supply growth was growing at 35% y/y at the end of 2009, but has turned negative in January; it's the single most important driver of CPI inflation, boosting prices with a lag of six to nine months, and has exceeded broader M2 since mid 2009. Proxy measures of inflation expectations, such as the difference between demand and time deposits, look to be rising as local asset prices have boomed. Acceleration in Chinese CPI inflation to around 5% by mid-2010 is likely and 6-7% by year-end if excess liquidity hasn’t been drained by then.
While tightening moves, in addition to current administrative measures limiting credit growth/investment, will probably take the form of further rises in reserve requirements and interest rate hike, an attractive alternative means of curtailing the nascent asset bubbles and at the same time rebalance the economy, is to revalue.
The consensus is that China won’t risk undermining a ‘fragile’ recovery by undertaking a radical currency adjustment, but there is nothing fragile about growth likely to hit 11-12% y/y in Q1. Chinese PMI indicators, and particularly the gap between new orders and inventories, indicate further strength in industrial production through the next few months and rising input price pressures.
Although official statistics can be massaged, recent electricity output growth to 9.5% y/y endorses other activity data. The real fragility is less the composition of GDP (although it is far too energy and capital intensive) than that China is importing US monetary policy via its dollar peg and thus inflating local investment bubbles and driving investment misallocation. Restraining liquidity indirectly by revaluing would allow interest rates to remain low and bank reserve requirements accommodative for longer.
The PboC is the only central bank in the world in the last decade to both identify and deliberately puncture an asset bubble when it tightened liquidity in 2007 to restrain the Shanghai stock market. To that extent, it has more credibility than most of its peers in the developed world.
It’s a myth that a substantial revaluation will undermine Chinese exports overall; in fact the trade surplus is likely to rise, as we saw during the 21% 2005-8 appreciation (and indeed in Japan during the 1980’s Yen bull run), as the import bill falls faster than any volume effect on exports.
In any case, only about 50% of net value added in Chinese manufactured exports is generated locally (and only 10-15% of product final sale value accrues to local factories), so much of any adverse trade impact of revaluation would be felt outside China. A policy of gradual appreciation encourages speculative inflows and makes the task of controlling domestic liquidity conditions difficult, as the PBoC found during the 2008 inflation spike. A substantial, one-off revaluation of the RMB would serve to limit inflows betting on further imminent rate adjustment, particularly if the explicit dollar peg was simultaneously abandoned. Above all, this is a crucial step toward ultimate RMB convertibility over the next decade, which will require far more sophisticated and deeper Chinese capital markets.
In fact, it is the agricultural sector that is most exposed to revaluation risk, as it remains hopelessly uncompetitive. Clearly, supporting rural incomes (which have lagged urban by a wide margin this decade) is a key political priority to maintain social stability.
This isn’t an insurmountable obstacle, particularly as China is becoming a net food importer for the first time in its history, the result of rising incomes and a more protein rich diet. Increased transfer payments to rural areas, following the US and European examples (and this year’s subsidy programs) would offset the income impact of rising imports. The world food market is likely to remain tightly balanced in the medium-term after decades of underinvestment, and on balance greater buying power is in China’s strategic interest.
China’s sale of RMB to maintain the dollar peg has not only sent the domestic money supply soaring but contributed to more than $150 billion in speculative ‘hot money’ flows from overseas in the past six months, according to China International Capital Corp. Chinese consumer spending accounts for only 35% of nominal GDP (compared to about 50% in S. Korea and Malaysia, and 55-60% in India, Thailand and Taiwan) and much of the reason lies in the declining share of the rural consumer. Broadly, household income has lagged economic growth by 2% of GDP annually.
Like Japan, Chinese planners have consistently favored producers over consumers, and construction and manufacturing over services. That policy is now unsustainable, and again revaluation is the most consumption-friendly means of tightening domestic liquidity. China urgently needs deeper capital markets as a precursor to eventual convertibility. It also needs a means to better manage domestic liquidity by restraining unofficial speculative flows.
Above all, the country has to cull the chronic overcapacity that has built up in sectors from cement to steel and the best way is to provide a bigger role for price signals in dictating business strategy. Revaluation helps achieve all of these key aims, at very manageable cost and an 8-10% one-off move followed by a new peg arrangement by H2 is increasingly likely.
Disclosure: Author holds a long position in UUP