China’s central bank has changed the language in its monetary policy report, raising hopes the yuan will be allowed to appreciate. But expectations of a big rise in the next year are over-optimistic. The currency is not as undervalued as many think and the economic risk is still of deflation, not inflation. Besides, the central bank does not have the final say.
In the report, the bank departed from its usual language on keeping the yuan “basically stable at a reasonable and balanced level”. Many took this as a shift from an effective dollar peg that has been in place since mid-2009. The offshore yuan forward market jumped, and is now pricing in a 3.3 percent appreciation in the next year, compared with 3.06 percent before the announcement.
Yet investors should not get too excited.
First, the old language did not prevent the authorities from allowing the yuan to appreciate by more than 20 percent against the dollar since 2005. So the change of tone does not necessarily signal a shift. Second, exports are still falling at double-digit rates and consumer prices are still down year-on-year, so there is no urgency to revalue the currency. Third, the central bank is not the final arbiter on matters related to the currency. Such a sensitive issue would have to be decided by China’s State Council.
Moreover, the yuan is probably not as under-valued as many think. While it is true that the yuan has been one of the weakest emerging market currencies during the last eight months, it was one of the strongest during the crisis. On a 14-month view, the yuan is still stronger than most other emerging market currencies.
U.S. lawmakers have said that the yuan is undervalued by some 30 percent, but Datastream, a Thomson Reuters company, says that the yuan is only undervalued by about 4 percent if measured by purchasing power parity, which compares the true cost of goods in different countries.
Admittedly, purchasing power parity is not a perfect indication of a currency’s value, as exchange rates can easily overshoot. But that is exactly why the People’s Bank of China does not want to put the exchange rate in the hands of the markets. A sharp rise in the yuan would wipe out Chinese exporters. Beijing is unlikely to allow the currency to move before exports have shown a consistent recovery.
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3 comments so far
Hooray for Datastream, the voice of reason ! Interest rate parity examples could also be interesting, even though I do not rate interest rates at the moment, especially considering the Fisher-effect. Cross-rate arbitrage always paints a different picture.
- Posted by CasperPresently, Yuan is peg with dollar. Now, China is saying that Yuan will peg with the basket of currencies. This shift may force China to lose its tight control over Yuan. The appreciation in Yuan may also be beneficial for China’s focus on domestic economy.
- Posted by CA. Rajay Kumar AggarwalEven if the yuan appreciates, it will make little difference in the trade imbalance between the U.S. and China. The global trade imbalances are driven by disparities in population density and not by currency valuations. An extreme population density drives down per capita consumption, making a trade imbalance between two nations grossly disparate in population density virtually automatic - essentially economic suicide for the less densely populated nation.
If the yuan appreciates, China will simply cut prices to maintain their market share in the U.S. Only the use of a tariff structure that is designed to counteract the effects of population density has any hope of returning the U.S. to a position of balance in global trade.
Pete Murphy
- Posted by Pete MurphyAuthor, “Five Short Blasts”