China Tells

In the last six months the foreign exchange policy of China has been on the headlines of most international newspapers. On one hand there is a lot of international pressure calling China government to reconsider its FX policy to peg the RMB to USD. On the other hand China government continues to state a firm stand that FX policy is a domestic only issue, which will not be affected by foreign impact.

Before we make a judgment call on whether RMB should be revalued, it is probably advisable to go through the main arguments to push China government to change the FX policy first. Such a review shall give us some hindsight before we form an opinion.

To summarize, following are the main points from economists and journalist to argue for a revaluation of RMB:

1) RMB has depreciated against most of world’s currency in the last 8 months, mainly due to the fact that USD has depreciated during the same period and that RMB is de factor pegged to USD. Such depreciation has hurt the competitiveness of other exporters such as Japan, Brazil and Germany and therefore should be adjusted back;

2) The revaluation of RMB is a key component to address the ‘global imbalance’. Such an imbalance, mainly represented by the over consumption and indebtedness of America and excessive surplus and over saving of China, is the culprit of the 2008 financial crisis. To avoid such crisis to happen again, the imbalance shall be corrected through the revaluation of RMB;

3) China’s economic growth is over dependent on investment and there is a lack of domestic consumption to push the economy to grow further. A consequence of such growth model is that the economy will have to rely on export sector to absorb its giant production capacity. To lessen the dependence on investment and export, and increase the domestic consumption market, China government need to de-peg RMB from USD and let the market determine its fair value.

Unfortunately, a close review of all the above points will reveal that none of these arguments are solid without flaw. First, it is true that RMB depreciated along with USD against most other currencies in the last 8 months. However, if we expand the time scale to August ’08, when the financial crisis started to unfold, we will see a completely different picture. (See Graph from Chinatells) Due to the fact that RMB was pegged to USD, there is no depreciation or appreciation between RMB and USD during Aug 08 and Mar 09. However, most other currencies, particularly those of emerging economies, depreciated from 10% to 40% against USD during that period, mainly due to the panic in the market and the desire of capital to fly back to safe heaven in the States. Therefore the appreciation of other currencies against USD during Mar 09 to Oct 09 is merely a valuation correction after the depreciation during Aug 08 and Mar 09. For example, Brazil Real (right most on the graph) depreciated about 30% during Aug 08 – Mar 09 before it appreciated about 35% during Mar 09 – Oct 09. As a result, the net effect is that Brazil real is almost unchanged to USD from Aug 08 to Oct 09, which is exactly same as RMB/USD. Such a result actually provides evidence to support a pegging system as RMB achieved same level of valuation with much less volatility.

The ‘global imbalance’ argument is a commonly cited point to argue for a revaluation of RMB. However, criticism on such argument has never stopped as well. For example, Mr. Zachary Karabell, the author of ‘Superfusion’, makes a good point that world economy has never been in a ‘balanced’ mode. (See ARticle from Chinatells) It is imbalanced after WWII, it is imbalanced during Bretton Woods, and it is not balanced during Tech bubbles either. Therefore it requests more robust evidence to establish a strong causality between the global imbalance and the 2008 financial crisis, and further a correlation between an undervalued RMB and the global imbalance. So far the perceived correlation between the exchange rate of RMB and the financial crisis through the link of global imbalance is at best a hypothesis, but far from a theory, and let alone a fact.

Last but not least, it is commonly believed that the investment ratio in China’s economic sector is too high and the GDP growth is excessively dependent on investment growth. However such a view probably has overlooked a fact that China’s saving rate is among the world’s highest as well. Below chart compares China’s current saving and investment ratio to some of the fastest growing economies in history. (See Graph from Chinatells) An interesting finding is that most economies during their fastest growing period experienced high saving and investment ratio. Given China’s current saving ratio at more than 50%, the investment ratio of 38% is actually not that high if compared to other economies. For example, during early 80s when Singapore went through a fast growing period, the investment ratio in GDP surpassed 40% with a saving ratio slightly higher than 40%. Similar scenario can be found in South Korea during early 90s and Taiwan during early 70s.

To summarize, none of the currently prevalent argument to push for an RMB revaluation is robust enough to be convincing. This is not to say that the current pegging system of RMB to USD is flawless and fair. Rather, the purpose of this article is to point out that to justify a revaluation effort for RMB, more work in depth need to be done and more sound argument with good logic need to be presented.

The original Article on Business Times can be downloaded HERE.