The US Treasury has slammed China again for returning to the old habit of intervening in the currency market to hold down the value of the yuan, just hours after official data showed the country has accumulated nearly $US4 trillion in foreign reserves -- the largest in its history.
Since the middle of February, China’s currency has depreciated 2.7 per cent against the dollar, breaking the long-term trend of appreciation due to intervention from the Chinese central bank. Most analysts believe the Chinese action was designed to punish currency speculators who believed the yuan was a one way bet and to prevent the influx of hot money into the economy.
The US Treasury Secretary Jack Lew raised this issue with his Chinese counterpart for probably the millionth time during a recent G20 meeting.
“During 2014 … the exchange rate has reversed direction, depreciating by a marked 2.68 per cent year-to-date,” the US Treasury’s semi-annual currency report says. “The Chinese authorities have been unwilling to allow an appreciation large enough to bring the currency to market equilibrium.”
So is China’s currency still undervalued?
The answer is surprisingly ‘no’ if you believe estimations from the Peterson Institute for International Economics, a prominent pro-trade think tank in the United States, and from well-regarded Stanford economics professor Ronald McKinnon.
Let’s start with Peterson’s estimation first. The World Bank released the latest purchasing power parity estimates of GDP last week, which better reflect the lower cost of living in developing countries. The headline-grabbing news, according to many analysts’ interpretation of the data, was that China would overtake the US as the largest economy in the world by the end of 2014 (The Chinese dragon is breathing smoke, not fire, May 2).
However, the comprehensive survey of prices across 199 countries in the world also affords an opportunity for economists to examine the controversial question of whether China’s currency is still undervalued. Martin Kessler and Arvind Subramanian of the Peterson Institute conclude: “We can say with some confidence that the renminbi is now fairly valued.”
This is a quite dramatic change. China has been pursuing a mercantilist policy of artificially holding down the value of its currency to encourage exports. As late as 2005, the Chinese currency was estimated to be 30 per cent undervalued against the US dollar.
Kessler and Subramanian use the PPP approach to estimate whether the Chinese currency is undervalued. Without going into too much technical detail, the basic idea behind the PPP approach is that there is a positive relationship between prices and income per capita known as the Balassa-Samuelson effect.
Poor countries usually have lower price levels -- especially in non-tradeable goods and services sectors -- and they can channel resources to tradeable sectors. A low price signals a depreciated exchange rate. So economists can calculate the equilibrium exchange rate and level of prices for a given level of income.
They illustrate this point in the below graph. Kessler and Subramanian use both linear and quadratic models to estimate the equilibrium exchange rate and the later model takes into account that the relationship between prices and income is weak for poor countries and more robust for emerging economies like China.
As you can see from the graph, China’s currency is only slightly undervalued -- by around 1.7 per cent in 2011 -- and even a tad overvalued if we believe the quadratic model.
In fact, we should not be surprised by this result. The Chinese yuan has been steadily increasing for the past few years. The real appreciation of the yuan was about 7 per cent between end of 2011 and March 2014, according to the Bank of International Settlements.
China’s current account surplus, which is another visible sign of the country’s undervalued currency, has declined significantly in recent years. For example, China’s current account surplus as a percentage of GDP was 10.1 per cent in 2007 and it declined to only 1.9 per cent in 2011. China’s current account surplus is still pretty big, only because the economy has grown at 9.8 per cent for the last 30 years.
Ronald McKinnon, a highly regarded economist from Stanford University, also argues that the Western demands for yuan appreciation are misguided. The trade imbalance between the US and China is largely due to the US fiscal deficit. And the continuous fall in the wholesale price index -- the best measure of tradeable goods prices in China -- suggests the yuan may even be slightly overvalued (China's currency conundrum, April 29).
Yi Gang, a deputy governor of the Chinese central bank who is in charge of looking after the country’s foreign reserves, made it clear at the beginning of the year that the country would float the Chinese currency soon and that the exchange rate between the yuan and the US dollar was close to equilibrium.
Yi, a former star economic professor, is in fact quite happy for Chinese consumers and importers to benefit from the rising value of the yuan. However, he didn’t rule out central bank intervention in the foreign exchange market in the future. He said future intervention would be rule-based and free from political interference (Cashed-up China Inc needs to spend, December 5, 2013).
Kessler and Subramanian, McKinnon and Yi’s estimates all suggest that the Chinese yuan is fairly valued against the dollar. This heralds a new age when China starts to abandon its decade-long mercantilist practices of holding the value of yuan.
The end of Chinese mercantilism -- and relief for the rest of the world -- may be in sight, say Kessler and Subramanian.