11 January 2010 – Chart of the Week

Chart of the Week: Whither the Yuan

Global policymakers want the yuan to go up. Purchasing power parity suggests that the yuan might go the other way.

China’s exchange rate policy is a powerful reminder that, at its core, it remains a centrally-planned economy. Indeed, government officials proudly contrast the stability of the yuan to the wild gyrations in the dollar. As Yao Jian of the Ministry of Commerce put it last November, without evident irony, “China keeping a basically stable exchange-rate policy is, in reality, good for the global economic recovery … If the request is to strengthen other currencies, while allowing the dollar to keep weakening, that’s not very fair.”

Of course, since China’s currency was effectively re-pegged to the dollar at the outset of the crisis, the yuan was only stable with respect to the dollar. For the rest of the world, by definition, the yuan has been just as volatile as the dollar. Global fury has been intense, initially directed at the US but increasingly at China directly, as at the Pacific Rim conference late last year and from French President Sarkozy early this year, who accuses China of “monetary dumping.”

While China has always kept a firm grip on its currency, it has not always had a dollar peg. Back in 1980, for instance, it took just 1.5 yuan to buy a dollar. Over the next decade, the central planners pushed the currency down by eighty percent. It therefore took a lot more yuan to buy a dollar, peaking at around 8.6 in 1994. Soon thereafter, as international trade gained importance for China’s economy, the planners pegged the yuan at 8.3. In mid-2005, under considerable international pressure, China shifted to a “managed float” of basket of currencies (but mainly the dollar) around which a tight valuation band was set for the yuan. In effect, the planners managed the yuan’s value up, and at an accelerating pace. Then the financial crisis hit and the peg was effectively reestablished at 6.8.

Remarkably, although the currency has always been controlled in one way or another, the yuan’s trajectory has generally hewed closely to that predicted by “purchasing power parity,” or PPP. The basic concept is that identical goods should have identical prices around the world. So if prices are going up in one country then the value of its currency should go down, all else equal, thereby preserving overall parity in the global economy. (The Economist whittles the idea down to its essentials in its Big Mac Index.) In a simple model, relative strength of the consumer price indexes of China and the US can be regressed against the actual exchange rate to determine a predicted value. The chart shows how tight the fit has been over time.

In the 1980s China’s inflation rate was considerably higher than in the US, the value of its currency should have gone down, which is just what the central planners engineered. More recently, when the peg was popped in 2005 the yuan had become undervalued, and the planners managed its value up. However, once purchasing power parity was reached, the yuan continued to appreciate. There are good reasons to retain a healthy skepticism about PPP (and the whimsical Big Mac Index gives a different signal, as does the World Bank’s far more complex model). Even so, at least on this one measure, the Chinese yuan appears currently overvalued to the dollar. Rather than strengthening to 6, a freely-floating yuan could weaken toward 8.

New trial balloons have begun to appear that suggest policymakers are considering a shift in currency policy. In particular, Zhang Bin, a prominent academic at the Chinese Academy of Social Sciences, has recommended for a one-time 10% rise in the yuan against the dollar, after which it should be allowed to rise and fall as much as 3% each year against a basket of currencies. The 10% rise would certainly assuage many complaints around the world. The surprise could come with the basket. If China broadens its basket to give greater weight to non-dollar currencies, particularly the euro, any further weakening in the dollar would be dampened. But so too would any strengthening of the dollar, a prospect that appears increasingly likely as the US recovery continues to gather momentum.

Models aside, having enjoyed a stealth devaluation by pegging to the dollar during the decline and expanding their global market share along the way, China’s planners could be set to lock in some of those gains by abandoning the peg before a major strengthening of the dollar.

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