A Brief Look at Yuan Valuations

 |  Includes: CNY, CYB, FCHI, FXI, FXP
by: Econ Grapher

With China continuing to see high inflation and the PBOC implementing a series of monetary policy tightening moves, the Yuan (or particularly the Yuan-Dollar exchange rate) has been highlighted as a potential inflation fighting tool. To be sure, there is also the ongoing chorus from the US urging China to allow a more flexible exchange rate. They say the exchange rate is artificially kept high; granting China an advantage in trade. So with these points in mind, and noting the impending talks between China and the US, it is timely to take a look at some Yuan data, and perhaps developing an informed view.

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First up is a look at PPP, or purchasing power parity, rates. The Purchasing Power Parity concept was made famous to the masses thanks to The Economist magazine with its "Big Mac index." Basically it says that if you factor in exchange rates the price of a McDonald's (NYSE:MCD) Big Mac should be roughly the same all around the world (of course life is not that simple, but for the most part it should roughly hold). Likewise PPP says that if you adjust for exchange rates then prices should be basically equivalent in every country.

So the above chart shows, via the red bars, where the PPP (OECD/IMF numbers) implied exchange rate should be for China. So on a PPP basis the Yuan is undervalued at current levels i.e. in 2010 you needed about 6.77 Yuan to buy 1 USD, whereas the PPP rate would suggest only about 3.95 Yuan should be required to buy 1 USD. Of course exchange rates can and do vary significantly around PPP rates, but the conclusion holds.

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Looking at the BIS (Bank for International Settlements - the 'central bank for central banks') effective exchange rate data, effective real exchange rates have been relatively closely matching the course of the USDCNY exchange rate. If anything it kinda suggests a more rapid downward course for the rate over recent times. But it is interesting to reflect on this chart, at how the Yuan has appreciated - about 25% since the initial move in 2005. While inflation has been pushing PPP valuations very gradually closer to the actual exchange rate, there has been an appreciable move in the Yuan also.

The question is when will the exchange rate hit the PPP implied rate? Or perhaps, how will it do that? If pressed, I would say the slowly-slowly approach to Yuan appreciation will continue. China may be able to use the exchange rate as an inflation fighting tool, and there is the continual pressure from around the world for China to make its currency more flexible. So is there scope for a more accelerated pace of appreciation in the near term? Probably.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.