Is It Time for the Yuan to Rise?
Even though China has allowed the currency to rise against the dollar in the past few years, in trade weighted terms, the Yuan has actually fallen by about 10% since 2001 on the back of the fall in the dollar. China has become even more competitive. And that competitiveness is fueling its growth. Let's look at a chart and some quotes from one of my favorite sources, Bank Credit Analyst.
This undervaluation "has fueled China's economic boom: China's exports have shot up massively, its current account has exploded upwards and its official reserve accumulation has sky-rocketed. Chinese manufacturers, aided by a super-competitive currency, have rapidly gained market share around the world. Chinese exports as a share of global trade was less than 3% in 1997. Today' it is close to 9%." (Bank Credit Analyst)
And BCA estimates that the Yuan is about 20% undervalued, based up purchasing power parity on consumer prices. But the less scientific and always interesting Big Mac Index suggests the number would be more than half overvalued by 56%.
A Tough Choice for China
There is a rule in economics. Central banks can control the value of their currency or the level of interest rates, but not both. You have to make a choice. China has chosen to control their currency against the dollar, but that means that interest rates are way too low. Real interest rates on bank loans are only 4% with real GDP at 11%. These low real rates are part of the cause of speculation and capital spending. If they allowed or forced rates to rise in order to help moderate growth and speculation, it would create even more demand for Yuan. As BCA notes, "The Chinese central bank is trying to achieve the impossible by suppressing both the Yuan and interest rates. The potential consequences of this policy are a rapid build-up in economic and financial distortions, a misallocation of resources and even a return of regulation on capital account movements."
Let's be clear. The politicians in Congress are right. China does have a huge advantage because of it lower currency policy. But the problem is a two way problem, and not just the fault of China. The US is the enabler in our co-dependent relationship. We continue to borrow and spend and consume. We do not save enough on our own to finance our own spending. We run a fiscal deficit which must be financed from abroad. Congress seems to think a weak currency is good policy for the US, but bad when the Chinese want to do it.
The solution is simply that we should be patient because the Chinese are going to have to deal with the problems that the policy is creating for themselves. Chen Zhao at BCA convincingly writes that the Chinese should float their currency now, and his arguments, or something like them, are certainly being discussed among Chinese authorities. If the Chinese do not get their runaway economy and misallocation of assets under control, they run the risk of a series of massive bubbles. Chen argues that:
"All of these economic problems suggest it is high time for the Chinese government to take bold steps to float the Chinese Yuan. Needless to say, there are legitimate concerns over the potentially negative impact a revaluation will have on Chinese manufacturers, but there are many major positives that will come with a freely floating Yuan.
"First, the authorities should not underestimate the ability of Chinese manufacturers to absorb the impact of a stronger currency. During the Asian crisis, the Chinese Yuan was revalued by over 30% overnight because of the wholesale collapse in other Asian currencies. Chinese exporters not only survived the shock but also thrived.
"Today, we have a much stronger world economy than in 1998, and therefore a better environment to help Chinese manufacturers overcome the short term difficulties. It is also wrong to believe that a stronger Chinese currency always works against Chinese manufacturers. In fact, a revalued Chinese currency would lower import costs of raw materials, helping manufacturers preserve profit margins.
"Second, by floating the currency the foreign exchange market could help the Chinese central bank tighten liquidity expansion - a necessary move to contain asset bubbles and reduce the speed of economic expansion. By moving to a floating exchange-rate regime, the Chinese central bank will regain its ability to adjust interest rates to appropriate levels. This will not only help pave the way to liberalizing the financial system, but it will also stem any further misallocation of resources.
"Third, the Chinese have saved too much and consumed too little, creating a burgeoning current account. A strong currency will help the Chinese reduce excess savings by promoting consumption while discouraging net exports. This would be a healthy shift in China's growth orientation, which would also reduce trade tensions with the U.S.
"Finally, the Chinese government has a fear over floating the Chinese currency: The authorities have long been frightened by the prospect of an exodus of hard currencies, leading to a depletion of reserves and a currency crisis. However, the Chinese government should realize that circumstances have changed dramatically from the 1980s and 1990s.
"The headache today is that China has too much reserves and the government is trying to find ways to encourage capital outflows. In the meantime, China has been a huge net creditor, and its foreign debt is minimal. There is no risk of a currency crisis in China by making the Yuan a freely traded currency."
While I do not think we will wake up and find the gradualist Chinese simply announce a fully floating currency, I do think they will allow the Yuan to rise at an ever faster rate. It is entirely possible that the 20% overvaluation that BCA suggests could melt away in 3-4 years. But before we start cheering that result let's look at some of the consequences. There is, as they say, the potential for collateral damage (pun intended).
If they are not pegging the dollar that would allow the Chinese to shift their reserves assets into currencies that they KNOW are going to outperform the dollar because of their own actions. It is clear that part of the conundrum of lower long term interest rates is in part answered by massive foreign central bank investment into dollars. If that starts to go away, you will also see the conundrum of lower rates go away as well.
And that policy may in fact be happening as I write. Greg Weldon, on of my favorite purveyors of all things financial, offers us some interesting insight into the Treasury International Capital (TIC) data released Friday morning. He looked into some of the details that have to raise some eyebrows this weekend. It explains why stocks and US equities are soaring and US Treasury bonds are under such severe pressure. Let's look at the TIC data from Greg (
www.weldononline.com)
"*Total Net Foreign Purchases of Agencies ... $36.12 billion, more than double March's $15.14 billion, and FAR MORE than $2.43 bln in Feb.
"*Total Net Foreign Purchases of Equities ... $27.42 billion, more than three times the March total of $8.77 billion, and more than twice February's $12.39 billion.
"*Total Net Foreign Purchases of Corporate Bonds ... $33.53 billion, and while less than in March of February, the three-month cumulative total is a mind-blowing $124.24 billion.
"Between Agencies, Corporate Bonds, and Equities, foreigners made net cumulative purchases of $97.07 billion during the month of April. With that figure in mind, nearly $100 billion, we note:
"Total Net Foreign Purchases of US Treasuries ... $ 0.376 billion Yes, less than $400 million, or, less than HALF A BILLION. Out of $97.4 billion in "Net Domestic Securities Purchased", US Treasury paper constituted ONLY four-tenths of one percent of the total.
"There is NO fear. There is only excess USD liquidity that is flowing into everything EXCEPT the "low risk, flight-to-safety' sector ... the US Treasury market. Moreover, "Official Foreign Institutions" (ie: global central banks) were net BUYERS ... meaning ... private foreign institutions and investors were actually DUMPING US BONDS, and reallocating more heavily into equity purchases."
There is no reason to think this has stopped. It is driving the markets, raising both stocks and interest rates. And then Greg brings us to the point that is germane to our discussion on China. I haven't seen anyone else note this, which is one of the reasons Greg is a must read for me. He finds these details.
"MORE problematic ... and something NO ONE seems to be talking about, China REDUCED their holdings of US Treasuries. Again ... the Chinese Central Bank DUMPED US Bonds in April. Note:
"Chinese Holdings of US Treasury Bonds ... $414.0 billion, DOWN (-) $5.9 billion in the month, falling from $419.8 billion.
"Again, we magnify the point ... China sold 1.5% of their UST holdings. Bottom Line: the management of Chinese USD reserves (not to mention Korea, an active 're-allocator"), are helping reflate asset markets, and helping push US bond yields higher."
