(This is a guest post from FXIS Market Insights.)
Is the Chinese Yuan under-valued? Is it just right or should it be a freely convertible currency and allowed to float like other major currencies? The number of opinions on all sides of the currency debate feels like a hodgepodge and figuring out what’s really in the soup is potentially an unattainable goal, even for the smartest market observers. Anyway, let’s try to get a glimpse of what’s in the soup.
The debates about the “right value” for the Chinese currency are now at every level of the media, the government, the investment community and even the general public appears to weigh in on the issue. Earlier this week, US Treasury Secretary Timothy Geithner announced that he would delay the highly anticipated report determining whether China “manipulates” its exchange rate until after April 15. This politically motivated move might take some of the heat out of the discussions in anticipation of Chinese President Hu Jintao attending the Nuclear Security Summit in Washington early next week. But below the official line, public unrest is brewing and an increasingly hostile debate with some calls for trade barriers remind us of similar discussions about trade sanctions for Japan during the 1980s.
Before going any further though, let’s look at some historic rates to get a bit of a reference point.
Photo: FXIS Market Insights
Undoubtedly, the rise of the US Dollar during the 1980s and more so, the massive devaluation of the CNY in January 1994 from 5.8210 to 8.7219 created a favourable exchange rate environment for exporting goods from China. To what extent that favourable exchange rate continued to help China’s as a whole is less clear though. For instance, the gradual revaluation of the CNY starting in 2005 does not appear to have made a real impact on the growth in imports from China (see red line in the chart below). Perhaps the biggest dent in the trend was the global financial crisis of 2008-09 which put a big lid on US consumer demand.
Photo: FXIS Market Insights
Will the US trade balance improve from a stronger Yuan?
Many economists, Paul Krugman at the forefront, have called for China to re-value its currency and for the US to impose trade sanctions if Beijing were not to comply. Other economists feel that trade barriers are ineffective and that a revaluation of the Yuan won’t do much to reduce the US trade deficit. The latter argue that most goods imported from China are those consumer goods that the US cannot or will not produce domestically anyway. If US consumers don’t buy from China, they will import it from somewhere else. Perhaps the trade with China may suffer but the overall US trade balance won’t improve.
Change is looming upon us however. From within China, there are now some signs that indicate Beijing might pull the trigger and revalue its currency some time this year.
In the financial Blogs, the debate has been ravaging for a long time now and rather outspokenly so. Opinions have been flying left and right with some increasingly aggressive stances, as if the financial crisis the global economic challenges could be solved by simply adjusting one currency to the upside. The issues are of course extremely complex and the ubiquity of possible implications is probably out of reach for one mind to fully grasp (certainly too complex for mine).
Please consider the following blog post “Why Re-pegging the Yuan and Other Non-Free-Market Solutions to Trade Imbalances With China Will Fail” by Mike “Mish” Shedlock.
This is one of the many articles featured in financial Blogs recently, but it’s a very good example of how complex the issue of the Chinese currency debate has been. Mish, a highly respected blogger who typically employs a healthy dose of common sense when examining financial markets seems to struggle wrapping his head around the issue in a sort of “all over the place” (unusual for him) approach to making sense of the debate.
How confusing the issue can be shows up in the information exchange between Mish and Michael Pettis. Pettis, a professor at Peking University’s Guanghua School of Management, specializing in Chinese financial markets, first writes:
“…to use a controversial example, if the US were able to force up the value of the dollar by 20% or more against all other currencies, it would become far more profitable to produce cars domestically, it would revive the aluminium and chemical industries, and it might cause a significant divergence of electronics assembly to the US.”
He then later replies:
“Mish, sorry, I meant force “down”, not up. The point is that if the dollar were devalued by 20%, the immediate impact would that US manufacturers would become much more profitable and foreign much less so. That would shift US and foreign consumption of cars from foreign producers to US producers, and would of course have a positive impact on US employment.”
Was that a Freudian slip by Dr. Pettis, a simple typo or was it just a reflection of how difficult the issue is in terms of deriving a somewhat simple solution?
Just taking a small bite out of Pettis argument with regard to cars, the answer is not entirely based on exchange rates nor is it simply price-driven. US car manufacturers might export more cars but it is questionable if they would sell any more domestically. US consumers have turned their backs against American car manufacturers because they have been building lesser quality cars. It’s not the price alone that drives consumption, point in case Apple computers: If the product is of exceptionally high quality, consumers will find the money to buy the product. Conversely, if a product is “cheap” but not that attractive, why buy it? The same argument goes for overseas consumers who are actually less price sensitive and given a choice would rather opt for a premium brand.
When and How?
What about a solution then? It’s complicated to say the least and for many analysts, the question is no longer if but when China will drop the currency peg. That however, has numerous implications, not all of which are positive for the US.
“When” China lifts the currency peg, inflation will also be imported in the US which, at current levels of unemployment, will not bode well for the cash-strapped US consumer. A fall in the value of the US Dollar and a possible crash in the Bond market may hurt both Chinese as well as US investors – with about $900bn, China is still the largest holder of US Treasuries. And, the Fed will be required to raise rates to find buyers willing to fund the immense government debt. None of these measures sound all that appealing.
At the same time, China is beginning to realise that decades of managed exchange rates have come at a price as well. Domestic inflation in China is as high if not higher than GDP growth. As long as the Yuan is relatively cheap, the commodity hungry Chinese manufacturers will struggle maintaining their prices as commodity prices are on the rise again. Last not least, China is sitting on upwards of $2 trillion worth of US assets and will not tolerate to have these asset values depreciate drastically. Any move on the part of China will therefore be highly calculated and timed well, making small gradual adjustments only.
In the long-run, letting the markets determine the “right” exchange rate appears to be the most sensible solution. Because of the complexity and a myriad of unforeseen consequences that a managed exchange rate could bring, the market may have the best shot at finding the “right” exchange rate, even if that rate were to change on a daily basis. Getting there however, will take some time. Meanwhile, today’s hodgepodge of a currency soup might not be to everyone’s taste. But as Mish pointed out in his article:
I am certainly in favour of letting the free market solve all of those. Indeed many of them are so intertwined, that only the free market has a chance in hell of solving them.
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