There is a steady drumbeat coming out of Beijing: the yuan is approaching equilibrium with the U.S. dollar. Prime Minister Wen Jiabao got it going earlier this year. Scores of Chinese officials and economists have picked it up. It is starting to reverberate among economists and analysts at the foreign banks and securities houses that have enjoyed a one-way bet on the Chinese currency for years. On cue, the yuan has reversed course in recent weeks, falling to its lowest level since mid-March. The sound is more incessant than ever.
Does it deafen to deceive?
The numbers show that since the peg with the U.S. dollar was broken in July, 2005 the yuan has risen by 30% against its American counterpart. The chart to the right shows how many dollars a yuan has bought over the past eight years. Were it expressed as the yuan a dollar buys, it would show the Chinese currency appreciating from its 2005 peg price of 8.2765 to the 6.3043 it averaged in April. There was a period in the aftermath of the 2008 global financial crisis when a peg was temporarily restored. Once loosened, the yuan resumed its rise. Adjusted for inflation, and particularly the relative changes in Chinese and American labour costs, the yuan’s rise against the dollar is as much as 50% since the 2005 peg was broken.
This upward revaluation of the currency has not stilled the voices in America complaining that China keeps its currency undervalued in order to support its exporters. During his recent visit for the bilateral security and economic talks, U.S. Treasury Secretary Timothy Geithner said that the currency should move higher against the greenback to allow for more flexible policy. It was a more nuanced call for a further rise in the yuan than he has voiced previously. That may reflect a better understanding on Geithner’s part than that of American trade protectionists of the reasons that China needs to let the yuan appreciate to help force the rebalancing of its economy. Yet it also recognizes the reality of the change in the exchange rate that has occurred, not popularly acknowledged in the U.S., while simultaneously giving a necessary nod to domestic political realities in a U.S. election year.
Not even the most obdurate American China-basher can gainsay that the yuan is now closer to its equilibrium rate with the dollar than it was when it was pegged. Yet how much further, if at all, does it have to go? Not an easy question to answer. It takes two to make an exchange rate. Not being fully convertible, the yuan doesn’t have a free market where its equilibrium price is readily discoverable.
China’s central bank determines the rate by restricting the currency to floating in a narrow margin around a fixed base rate determined in reference to a trade-weighted basket of currencies. The bank doubled the permitted daily trading band in mid-April to 1%, a small step in a long journey to fuller convertibility of the currency. It was said then that current conditions–slowing economic growth, weak export markets and investment outflows in the wake of looser currency controls–would be more likely to push the yuan down than up. So it has proved, an outcome welcome to policymakers, who can point to the market, not them, manipulating the direction of the currency in a way that happens to favor the country’s hard-hit exporters. We’ll overlook the conveniently woolly confusion of the outflow of funds on the capital account with a trade imbalance on the current account.
A plateauing of the yuan’s upward revaluation may indicate that equilibrium is near, but it is not a confirmation of it. Economists commonly use two methods to estimate equilibrium exchange rates. One set uses purchasing power parity, which assumes that exchange rates will come to equilibrium at the rate that aligns prices between countries. The second approach is to look for the exchange rate that would allow for an equilibrium balance of payments.
Much of the case for the yuan approaching equilibrium turns on applying the second approach. China’s current account surplus has fallen from 10% of GDP in the mid-2000s to somewhere likely to be between 2% and 3% this year. Next year it may fall to 1.5%. In macroeconomic terms, that is as near to an equilibrium balance of payments as makes no difference.
Yet beating the drum for that approach doesn’t necessarily make it so. Joshua Lipman of the Wharton School of the University of Pennsylvania, in a paper published last year, calculated that the equilibrium rate using purchasing power parities was around 4 yuan to the dollar. He also reckoned that using the equilibrium balance of payments approach, the figure should be and somewhere between that and 5 yuan. He did his sums when the current account surplus to GDP ratio was higher. A recalculation today should push the figure towards or past the higher number. Using either method, however, implies the currency is still undervalued, if by an ever decreasing amount.
Lipman notes, and the chart above shows, an important point: the central bank has managed the appreciation of the yuan by letting it rise steadily, an average of 6.4% a year since the peg was first broken. If that rate were to continue, the yuan would take until mid-2015 to reach five to the dollar and a further three years to reach four to the dollar, the range of Lipman’s computed equilibrium rate.
By letting the exchange rate move only within a narrow daily band, China has managed to avoid the shock to its economy from a rapidly rising exchange rate that Japan endured after the Plaza Accord in 1985. Intended to end the undervaluation of the Japanese currency against those of its main trading partners, the accord led to the yen doubling against the dollar in two years (see chart above). That triggered the endaka recession and then the monetary expansion to counter it that inflated a property and debt bubble that was followed by Japan’s so-called Lost Decade. Those were lessons not lost on Beijing’s policymakers.
One lesson that was lost on many Westerners, or at least has been widely forgotten, was that the forced rapid appreciation of the yen, did not eliminate America or Europe’s trade surpluses with Japan in the 1980s. They were caused by structural issues requiring different remedies. The same is true of China’s surpluses. Getting its currency in equilibrium is part of ending its own economic imbalances. As they apparently say in India, or at least in movies about India, everything will be all right in the end–and if it’s not all right, it is not yet the end.
China Bystander 