Currencies: The Case for a Stable Chinese RMB
morganstanley.com
Stephen L. Jen (from Hong Kong)
Balancing out the debate on the Chinese RMB
The debate on the RMB so far has been of surprisingly low quality, in my view: the same logical rigour applied to other debates is not evident in this particular debate. Not only do I believe some arguments used to argue for an upward RMB revaluation are outright illogical, but this debate has been remarkably lopsided, with few offering a defence for Beijing’s position, which, in my view, is rather compelling. In this note, I present rebuttals to several of the more popular market misconceptions about the Chinese RMB, and offer an explanation of why I believe Beijing should and most likely will maintain a stable USD/RMB for the time being.
Misconception 1. China is the source of global deflation
The 'China bashing' campaign is gaining momentum, not just in Japan, but even in the US, as commentators are blaming China for being a source of global deflation. In recent weeks, Japan has stepped up its criticism of China as the primary exporter of deflation — as hurting not only Japan but also the global economy: First, by dumping cheap products on the global market, China is pricing producers from other countries out of the market. An RMB revaluation should solve this problem, so the argument goes. Second, in his recent op-ed piece in the FT last week, the MoF’s Kuroda partly blamed China and SE Asia for much of the world’s deflation problems and pointed out that China itself suffers from deflation. The solution, he proposes, is for China to re-value the RMB.
Rebuttal
First, though China may very well be putting downward pressure on global tradable goods prices, I believe this is good deflation, something that the rest of the world should be pleased to see, just like a fall in oil prices. A critical distinction between good and bad deflation should be made by commentators on China’s RMB policy. The type of deflation exported by China is ‘good’ deflation — the kind caused by low-cost production. In contrast, the type of deflation exported by Japan is ‘bad’ deflation — the kind resulting from inadequate demand. If an American consumer needs to now pay only US$10 for something made in China that he used to pay US$30 for when the item was made in Mexico, is this deflationary? Clearly it is not! While the individual good's price will fall, the consumer will spend the US$20 saved on something else. There is no reason why overall demand should fall, or the general price level should fall. Second, if China itself is suffering from deflation, should it not massively hydrate its own economy and devalue the RMB, rather than re-value upwards? This argument that China should re-value the RMB may make sense from Japan’s perspective, but certainly does not from China’s perspective. Exchange rate adjustments are a way of transmitting nominal shocks (e.g., inflation/deflation shock). By adjusting the exchange rate, a country can either import or export deflation. What Japan is doing via keeping a weak currency bias, is to 'import' inflation, which is the same as exporting deflation. Some could even argue that Japan is as big an exporter of deflation as China is, given that in terms of nominal GDP, Japan is four times as large as China. Those who argue that China should accept a stronger RMB are essentially suggesting that China should bottle up its deflation for the sake of the rest of the world. Given China’s low per capita income and the challenges facing China in coming months and years, I think this seems somewhat unfair.
Misconception 2. The RMB is grossly undervalued
It has been argued that China has benefited from an ‘artificially undervalued’ RMB and that such persistent undervaluation is unfair to countries that compete with China. After all, so the argument goes, combining China’s productivity growth and inflation differentials, the RMB could have been depreciating in real terms by as much as 10% a year.
Rebuttal
Determining the fair value of a currency is difficult, particularly when there are major structural changes that are almost impossible to model. China’s case is arguably more difficult than most other cases, precisely because of the scale and speed of the structural changes that have been taking place. I have yet to see a technically robust calculation of the 'fair' value of the RMB, and am puzzled how critics of China’s RMB policy could be so confident that the RMB is under-valued, without having done such a calculation. The claim that China is running a 'beggar-thy-neighbour' currency policy could be a result of confusion between two quite distinct concepts: (1) the fair value of the RMB versus (2) whether the RMB would rise if left to market forces. The upward pressure on the RMB comes mainly from the massive capital inflows attracted by what China could become, not what China already is. Forcing China to re-value now would be similar, in my view, to forcing Japan to re-value the JPY from 360 to 125 in 1972, just because Japan may have looked promising back then.
Historically, there has been a great deal of 'undisciplined' thinking on the valuation of the RMB. Back in 1998, the consensus view in the market was that the Chinese RMB was grossly over-valued, and due to crash. How can the RMB have been grossly over-valued five years ago, and be grossly under-valued now, when it has been pegged to one of the strongest currencies in the world — the US dollar — during this period? In fact, using the same method that yielded Japan’s MoF’s claim that the PPP determined ‘fair value’ of USD/JPY is in the 150-160 range, we compute that the RMB is slightly overvalued against the JPY! In my view, this latter conclusion is as wrong as the first, because they are both based on a method that is equally flawed (please see the article in last week’s FX Pulse, 'PPP vs. P P P,' F. Yilmaz and S. Jen, 5 Dec 02). In my view, Japan cannot argue that the fair value of USD/JPY is 150-160, while not accepting that the Chinese RMB may also be over-valued, using the same kind of calculation.
Misconception 3. China’s C/A surplus will explode via an undervalued RMB
China is on a steep growth trajectory. For an economy of this size, the implications for all potential competitors of China could be quite worrisome. One such fear is that China's C/A surplus will surge further. Not only will higher cost producers in the world be priced out of the market but, according to this line of thinking, China will hoard its savings and not spend (the reverse side of the coin to building a C/A surplus). This would then result in a net withdrawal of aggregate demand in the world, leading to further downside pressures on general prices.
Rebuttal
This argument above is, like the others, a 'partial equilibrium' concept, and not a 'general equilibrium' idea. If we believe that China is on a path to becoming one of the more productive economies in the world, then the expected return on asset premium should lead to a C/A deficit, not a surplus! In other words, global capital should be attracted to China en masse, if China is truly expected to generate higher return on capital on a sustained basis. Such a capital account surplus would compel China to run a C/A deficit — just as the US was 'forced' to do in the late-1990s.
In the coming years, China will need to invest heavily in all sorts of infrastructural projects. Many of the capital goods needed (e.g., power plants, bullet trains, telecommunication systems, etc.) must be imported. In my view, China's emergence will force all countries up the value-added ladder, but China will not displace all countries from the ladder. China will still need to consume, and will be a source of significant demand for the global economy. Already, we are seeing signs that China is a source of demand in Asia: exports from Korea and Taiwan have been extraordinarily strong since October, reflecting primarily strong demand in China. The fear that China will eventually 'crowd out' everybody is not only unfounded, it is irrational, in my view. China's becoming a source of global demand is consistent with my previous argument that China's cheap exports will not necessarily lead to global deflation, even though individual prices may fall.
China’s challenges
While China may remain an oasis of growth in this alarmingly weak global economy, it confronts daunting longer-term challenges, in my view. It has a banking system with a bigger NPL problem than that of Japan; it has to cope with the competitive pressures arising from being a WTO member; and it has to transform an immense agrarian society into an industrialised nation in a short span of time. These factors are structural negatives for the RMB and they translate into 'risk premia' for the currency, much like the case of the JPY. Currency stability at a parity that does not hinder China’s growth is critical. Re-valuing the RMB could choke off job creation in China — a risk that China has no reason to take now. Having said this, greater currency flexibility is a ‘next step’ and is indeed what China has already announced that it will do. However, the trading band will most likely be widened very gradually, allowing time for market participants in China to learn to hedge against currency risk. A one-off revaluation of the RMB is something that is totally different and very unlikely, in my view.
A stable RMB is good for Japan as well
I believe it is remarkable how much focus there is in Japan on China's RMB policy. The irony here is that a revaluation of the RMB, in my view, would not solve the problems in Japan. For Japan to successfully compete against China in areas which have previously been controversial for Japan, e.g. growing mushrooms or making straw mats, USD/JPY will need to be at 1,000 in my view. I believe the RMB issue is a red herring, in that by placing the blame on China, Japan distracts itself from doing what it needs to do (carry out substantial structural reform). This is a convenient way for the anti-reformists to divert attention from structural reforms, and toward measures such as currency devaluation and monetisation. At this pace, Japan will never solve its problems, and, theoretically, could be overtaken by China in terms of economic size, before too many years are out.
Bottom line
China has a strong case to maintain a stable RMB, at least for the time being. The justifications to compel China to revalue its currency are not convincing to me.
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