The much-feared
rise of the Chinese currency may be coming to a close, giving American
politicians a breather
In a few years’ time, it is possible that we could well see the Chinese
yuan return to the kind of relative obscurity (at least by large country standards)
that it so richly deserves -- an emerging markets version of the Japanese yen.
It is not an exaggeration to say that the yuan has been one of the
biggest economic issues to come out of the emerging universe in the past
decade. It is difficult to think of another topic that cuts across so many
different lines including politics, market investment strategy, structural
development debates and international relations – starting with fears that
China was unfairly distorting global trade and growth through a massively
undervalued exchange rate, and ending with the idea that the yuan is now
destined to topple the US dollar as the world’s reserve currency.
Attention has been based on four key macro trends: an extraordinarily
high trade surplus, rising global market share in virtually every export
category, steady, almost guaranteed trend yuan appreciation, and the rapid
policy-led opening of offshore trading.
The fun is now winding down. Each of these trends is now likely coming
to an end – which, in turn, implies the end of the Great Yuan Trade.
This doesn’t just mean the end of one-way yuan appreciation – although
that change is indeed looming on the horizon – but also the end of the Chinese
currency as a an important topic that dominates the attention of US
congressmen, global reserve managers, academics and conspiracy theorists
everywhere.
The End of
Surpluses and Market Share
The bottom line is simple: China’s current account surplus is slowly
but surely disappearing. It is already well under the “Geithner threshold” of 4
percent of GDP that constitutes a structural imbalance according to US Treasury
guidelines, with no real sign of any turnaround over the past 12 months. We
understand that past performance is no guarantee of future trends, but there
are at least three good arguments why the trade balance is not going to rebound
sharply any time soon.
First, there has been nothing close to a global recovery that would
lead to sustained strong double-digit trend volume export growth to developed
markets, and we don’t expect such a vibrant scenario going forward.
Second, there is little indication from China’s macro data that excess
domestic capacity is pushing the surplus higher from the supply side – and this
is after many quarters of policy tightening and weak demand.
Third, with local unskilled wages exploding upwards, China is already
losing market share in traditional manufacturing export industries such as
toys, textiles, footwear and sporting goods. Mainland firms are still gaining
ground in higher value-added sectors such as IT electronics, of course, but the
days of China eating everyone’s lunch are clearly over.
We do not expect the trade balance to go careening into serious
deficit, however, for the simple reason that the government is not easing
policy today and shows no interest in stimulating the economy a la 2008-09.
Indeed, we expect the most import-intensive parts of local demand such as
construction and infrastructure spending to remain flattish for much of 2012.
All of which means that the political noise over Chinese external
imbalances, unfair currency practices and exchange rate manipulation will
probably continue to fade from here. The yuan is no longer under major
strengthening pressure and it should come as no surprise that the exchange rate
has traded essentially flat against the US dollar since the beginning of the
year, with an unprecedented magnitude of two-way trade as well. We don’t mean
to say that the yuan can’t appreciate moderately. But it is increasingly clear
that this is no longer a unidirectional trade with guaranteed returns.
Could we actually see the currency depreciate sharply from here, as
some bears would have it? Not really. To begin with, as we argue, domestic
demand is simply not strong enough to push the trade balance into sizeable
deficit any time soon.
Moreover, the popular idea that China is threatened with a potential
flood of portfolio capital outflows is sorely misguided. Any top-down measure
of implied “hot money” inflows shows that there haven’t actually been any over
the past few years, at least not on a sustained basis in any significant
magnitude (Chart 4 above). Which leaves relatively little to go flooding back
out again. And need we even mention the US$3 trillion-plus pile of official FX
reserves?
The bottom line is that (i) there’s precious little chance that the
yuan will be anything but a heavily managed currency going forward, and (ii) it
is likely to be far more range-bound as well – some upside, perhaps some
downside, but no real drama.
The end of
liberalization?
We would feel differently, of course, if we thought that China was on
the verge of dramatic capital account liberalization that would open the doors
to far larger portfolio movements. This would not only make exchange rate
trading a more exciting proposition, it could also push the yuan onto the
global stage in a much bigger way and provoke a longer-term shake up of
international portfolios.
There’s just one problem: it’s not happening.
There are three key points to make here. The first is that despite the
rapid development of the offshore Hong Kong “CNH” market over the past few
years, there has been no corresponding opening of the onshore market.
How can we tell? As regular readers know, there is a quick and easy way
to measure the effectiveness of cross-border flows in any economy: simply
compare domestic short-term interest rates with the interest rate implied in
the internationally traded FX forward market.
Chart 5 below shows the behavior of the two rates series for China’s
more open neighbors, including Korea, Malaysia, Singapore and Taiwan. As you
can see, they are extremely close at any point in time, indicating a high
degree of capital mobility and thus close arbitrage.
Although Hong Kong deposits may sound like a significant figure, this
is still a tiny, even imperceptible drop in the bucket in terms of global
financial markets.
Nor, finally, do we expect the government to follow through to the
logical conclusion of its offshore yuan experiment, i.e., the integration of
local and overseas markets through a more radical liberalization in the near
future – or anything even remotely close to it. Despite some of the political
rhetoric coming from leadership circles, it’s not just that they “won’t” open
the capital account ... in a very real sense they can’t, at least not fast
enough to matter.
For more than two decades the entire philosophy of monetary management
and financial system development has been based on a closed-economy system:
maintaining low and stable interest rates without having to worry about
external arbitrage; breezily adopting economic stimulus when needed without
concern about underlying banking system asset quality; propping up banks with
historically high NPL ratios and fixed-cost pricing, and keeping iron-clad
control over the value of the exchange rate. All of these only work when
foreign portfolio funds cannot influence asset prices, and when locals have
nowhere else to go
And although it may be very much in China’s theoretical interest to
move to a more open and market-driven system over time, it is certainly not in
policymakers’ interest to jump-start the reform process at a time when the
economy is overextended with credit, banks are facing another wave of bad loans
and the government is in the middle of trying to slow the economy without
causing an undue shake-out in sensitive property markets.
That is, they are bound to get around to external liberalization at
some point, but it certainly isn’t happening today and won’t really be
happening tomorrow. So in the meantime get ready for the new, more obscure
Chinese yuan.
Jonathan Anderson
Asia Sentinel
Business & Investment Opportunities
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