U.S. politicians and other prognosticators like to blame China for manipulating its currency in order to achieve an unfair manufacturing edge against countries like the United States, where living standards are higher and workers are necessarily paid more.
If that’s the case, then it certainly appears to be changing — today, the value of the Chinese yuan climbed to its highest level in 19 years against the U.S. dollar.
Yet the Chinese yuan has basically been strengthening against the dollar in nominal terms over the whole timeframe since 1994.
And if we look at currencies in real terms, China actually has the least competitive currency in the entire world, let alone vis-a-vis the United States.
The Bank for International Settlements calculates indices known as “real effective exchange rates” (REER) to measure how undervalued over overvalued one country’s currency is in relation to another.
The real effective exchange rate is equal to 1 if goods bought in one country with its respective currency cost the same as goods bought in another country with the second country’s currency after applying the nominal exchange rate.
For example, if one buys a pack of gum for ¥6.11 in China, and he or she can buy the same pack of gum for $US1.00 in the U.S. after trading his or her yuan for dollars at the nominal exchange rate, the real effective exchange rate between the two currencies is said to be equal to 1 (because the current nominal exchange rate is $US1.00 = ¥6.11).
BofA Merrill Lynch strategists measure currency competitiveness on the basis of current deviations from one-year, three-year, and five-year REER averages.
By this measure, China has the most overvalued currency in the world, making it the least competitive.
The U.S. dollar is not particularly competitive either, but is much more so than the Chinese yuan.
Japan, on the other hand, after launching an experimental program of economic stimulus late last year designed in part to weaken the yen, now has the most competitive currency in the world.
“Figure 54 shows that Japan has a currency advantage globally, especially versus China, and Southeast Asia,” write the BAML strategists in a report. “A weaker currency helps market-share gains, raises inflation, raises nominal GDP growth, and given Japan’s high operating leverage, raises EPS growth above what investors expect.”