Almost all of the recent analysis surrounding China’s recent currency fluctuation takes for granted that China just joined the global currency war by engaging in competitive devaluation in an effort to spur exports and thus growth. We offer a different take, that the recent move that in effect loosens up control over the peg (slightly) is more a measure of ongoing reform than of competitive devaluation. Indeed, one of the hallmarks of a liberalized financial system is that prices are determined by market forces rather than a central bank or other government entity. In this respect, market participants should welcome the small move to make the value of the yuan more market driven. Given the now (more) freely floating nature of the yuan, market participants might also start to consider what the fair value of the yuan might be. In a challenge to the common knowledge that the Chinese yuan is currently undervalued and moving to be very undervalued, we propose that the yuan is in fact overvalued at its current level and would have to fall by between 30-40% to be considered a very undervalued currency in line with historical precedent. We think that is an unlikely scenario given the progress already made to bring down the current account surplus and increase consumption as a share of GDP, as well as China’s desire to get the yuan included in the SDR basket.
On the Value of The Yuan
When we look through our currency valuation toolkit we come to the conclusion that the yuan is probably overvalued by a decent margin (we are not nearly smart enough to put a specific number on it!). Looking at the JP Morgan Real Broad Effective Exchange Rate Index which takes into account relative inflation between trading partners, the yuan has appreciated more than any other major currency over the last five years (chart 1). It has appreciated by 26% versus US dollar appreciation of 11% and Japanese yen depreciation of 33%. Over the last year, the yuan has appreciated by 10%, the dollar by 15%, and pound by 7% while the euro and yen have both depreciated by about 10% (chart 2). In essence, by this measure of currency valuation, the yuan has appreciated by 26% over the last 5 years and 10% over the last year while its economy has slowed and it has cut interest rates multiple times. Usually slowing economies whose central banks are also easing see the currency slide, rather than appreciate.
From a purchasing power parity perspective (PPP), which takes into account relative price levels between countries on a bilateral basis, the yuan is currently overvalued by almost 15% relative to the US dollar (chart 3). When China was running an conspicuous mercantilist policy from 2001-2007 the yuan maintained an undervaluation level of about 15% relative to the US dollar. Since 2011 however, the yuan has been overvalued relative to the US dollar by about 15% according to this measure. As we will see shortly, the current account surplus has also been reduced massively since 2007, which is not a coincidence.
On “Real” Devaluations
When we look back at the last several years of financial history there are two currency devaluations that stand out relative to all others in significance. The first is the devaluation of pound relative to the dollar that took the pound down in nominal terms by about 35% from 2008-2009. The second is the devaluation of the yen which took it down by about 39% in nominal terms relative to the dollar from 2011 to today. In the case of the pound, our PPP metric indicated that the pound was overvalued by about 20% in 2007 and then progressed to being undervalued by nearly 18%, for a 38% swing (chart 4). In the case of the yen, our PPP metric had it being overvalued by about 13% to being undervalued by about 32%, for a 45% swing (chart 5). Now that is what you call devaluation! If the yuan were to stage a repeat of either of these it would be falling from about 15% overvalued to about 15-25% undervalued based on the PPP method. It would have a long way to go. Indeed, even the euro’s weakness has not been on par with the devaluation of either the pound or the yen. From a PPP perspective it was overvalued relative to the dollar by about 10% in 2014 and is now undervalued by 13%, for a 23% swing (chart 6). That meager 23% swing clearly has not been enough to get the fledgling euro zone back on its feet.
On the Great Chinese Rebalance:
By assessing the most blunt economic measures, it is clear that the China has begun the long process of rebalancing its economy from an investment led model to more of a consumption led model. The share of investment as a percent of GDP has fallen from a peak of 48% to 46% while the share of consumption has risen from a trough of 36% to 38% (chart 7). Eventually the share of investment should fall to around 35% while the share of consumption should rise to closer to 50% if China is to be more in line with its EM peers, which means there is still a long way and a lot of reforms to go. Additionally, the current account surplus as a percent of GDP has fallen from 10% to 2% since 2007, indicating a substantial lessening in China’s mercantilist ways (chart 8). Compare China’s effort to rebalance its economy to Germany’s effort and one can easily see the difference. Germany, the mercantilist of mercantilists, has done the opposite of China and continues to post higher and higher current account surpluses and is on its way to 10% of GDP (chart 9). These results have not come easy and we doubt China would change gears after the clear direction has been set. Indeed we are not sure China has much of a choice in the matter as debt sustainability becomes ever more of an issue the longer this rebalancing process takes.
One final point that many others including my colleagues at Gavekal have made, is that China has its sights set on inclusion in the IMFs Special Drawing Rights (SDR) basket. However symbolic gaining inclusion would be, China clearly wants it. One of the prerequisites is that the yuan make progress towards a market oriented pricing mechanism rather than simply track the dollar and thus in effect increase the dollar’s weight in the SDR basket.
Contrary to public opinion, we think the yuan is probably a bit overvalued at the moment and that a more market driven pricing mechanism of the yuan correctly moved it lower. This small step to liberalize the exchange rate and provide holders of capital a clearer price for China’s external cost of money is another small step that will eventually lead to improved allocation of capital in the country. Given China’s stated goals to rebalance its economy and gain inclusion into the SDR basket we think the probability of a pound or yen style devaluation is probably overstated by the market.