Conventional wisdom says the undervaluation of the Chinese yuan is damaging the global economy. Jonathan Anderson, chief Asian economist at UBS, disagrees. Here he explains why.
No matter who you are or where you live, it's a safe bet that China has had a bigger impact on your life over the last 18 months than ever before. The mainland now sells more than $500bn worth of goods per year to the rest of the world, with exports expanding at a 35% annual rate. At home, China's spending wave, including billions of dollars of over-investment in factories and property, has pushed global commodity prices to exorbitant levels. Internationally, the US dollar has become a hostage to China's economy. The People's Bank of China (PBoC) is already the third-largest foreign holder of US Treasury debt, and the biggest source of financing for the growing US budget and current-account deficits. It ploughs more than $100bn a year into dollar markets.
In short, it's been an astounding few years for China and the world - matched only by the amount of ink spilt on explaining how we got here. Despite the diversity of views, virtually everyone is agreed on the importance of one factor: that China keeps its exchange rate pegged at a rate of 8.277 to the US dollar.
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For manufacturers, the case is simple. The Chinese yuan is undervalued. Massive foreign-exchange intervention and reserve accumulation is needed from the PBoC to keep it pegged to the dollar at this low level. This keeps Chinese wages artificially low in dollar terms, in effect forcing prices down abroad and stealing developed-country jobs. For governments, the case is equally simple. In order for global recovery to continue on a sustainable basis, the US current-account deficit has to be reversed, either through a significant weakening of the dollar, or a sharp US recession. For the US to adjust without recession, it needs China to sell less and buy more, which means revaluing the yuan. For academics, it's a textbook scenario. If you fix the exchange rate, you lose control of monetary policy and inflation - precisely what has happened in China. And for investors, the arguments are straightforward. The US dollar is being propped up by China - but it can't go on much longer. Faced with managing an unruly domestic cycle, as well as a growing pile of forex reserves now approaching $600bn, the PBoC will soon cut its losses and give up the peg. And when the yuan goes, most other Asian central banks will loosen their de facto dollar pegs as well. Even if China chooses to go slowly, for example by shifting to a trade-weighted basket' arrangement in the near term, it still adds up to one thing: sell dollars.
Overall, the yuan seems to hold the key to a surprising number of domestic and international issues. But does it? The arguments above might sound convincing - but most of them are in fact wrong. Fixed or floating, up or down, renminbi exchange-rate policy simply doesn't have a major impact on the global economy.
Think of it like this. What would happen if Italy reinstated the lira, and decided to peg its exchange rate to the euro or the dollar at a rate 15% lower than now? The impact would be pretty limited. After all, Italy is relatively small compared to the global economy, and 15% undervaluation doesn't seem like a lot in the grand scheme of things. So why all the attention given to China? At $1.2trn, Italian GDP is roughly the size of China's, and Italy's total foreign trade value of $750bn is only slightly smaller than that of China's. First-world manufacturers point to artificially cheap Chinese wages as the most imminent global threat - yet artificially cheap Italian wages would hurt them much more, since most Italian industry is in price-sensitive sectors (autos, chemicals, machinery and technology) that compete head-to-head with other rich nations. By contrast, Chinese export workers make textiles, toys, sporting goods and light electronics - industries the developed countries mostly gave up a long time ago.
Consider the global trade data. Chinese exports have been penetrating European, Japanese and US markets at a headline growth rate of 35% per year - but overall Asian market share has grown very slowly, meaning that for each additional dollar industrialised consumers spend on Chinese imports, imports from the rest of Asia actually fall. This is not because China is outcompeting its Asian neighbours. Rather, crucially, it's because Asian countries have moved low-end assembly functions to China, as a final stop on the production chain before shipping off to Wal-Mart or Tesco.
Take the example of a $200 mobile handset assembled in China and then shipped to the US. The value-added share accruing to Chinese parts and labour might only be around $30; the remainder would be high-end components and equipment coming from Japan, Korea or Taiwan. So even if the yuan were revalued by 30%, the price of the handset would go up by just $9, not nearly enough to have an impact on American producers and jobs. But if, instead, the yuan remained fixed and the Japanese yen, the Korean won and the Taiwan dollar were revalued, then the price rises by nearly $50 - the level of hike that might actually provide relief to high-end manufacturers in the US. The lesson is that currency policies in more developed markets matter to a much higher degree than they do in China.
But what about all those forex reserves? Over the past 12 months, the PBoC purchased more than $170bn in reserves, or roughly $15bn per month - the current price of keeping the yuan constant. The People's Bank generally parks at least two-thirds of its funds in US Treasuries or other dollar assets; if China were to let the yuan strengthen, it wouldn't have to buy up as many reserves. Even if the authorities moved gradually, for example initially shifting to a basket' regime, they might want to move their reserves into other currencies, such as the euro and the yen. Either way, a change in the exchange-rate regime means a drop in Chinese support for the dollar, at a time when China seems to be the main source of funding for overstretched US consumers.
This is a compelling story, but probably a misguided one. To see why, ask yourself: Where do those billions in reserves come from every month? Over the past year, roughly half of China's forex reserve inflows came from portfolio capital, including so-called hot money flows. In effect, Chinese banks and firms have been drawing down their asset positions abroad, or borrowing money in foreign markets, and bringing these funds back to China, in part to speculate on a possible renminbi move. But this means that as private agents move out of dollars and into yuan, the PBoC is buying up the dollars and pumping them right back into the US. The net effect on US markets from these transactions is virtually zero! (This is an overly simplified explanation, but close to the mark.) So despite the size of the headline reserve accumulation, China's true support for the dollar is much smaller.
The really crucial factor is relative current account positions. This year the US current-account deficit is expected to reach $600bn. China's US surplus is $40bn - only a 15th of the size of the US imbalance. By contrast, Japan, Taiwan and Korea together should record a US surplus of around $230bn this year; throw in Singapore and Malaysia and the figure increases to $275bn. You get the picture: China is a relatively small player on the global scene, and its neighbours are much more important in determining the fate of the US economy.
This still leaves the undisputed fact that the PBoC already holds a large pile of dollar assets (estimated at $350bn or more). If the PBoC suddenly decided to sell its holdings and buy euro or yen instead, the negative impact on the dollar would be enormous. But why would it? The PBoC already holds a diversified asset portfolio, including a sizeable amount of euro instruments. And the central banks are conservative policy institutions, not hedge funds, and it doesn't serve China's interests to be seen shaking up G3 currency markets.
The bottom line? It's surprisingly difficult to argue that the Chinese renminbi exchange regime has had any substantial impact on the way the rest of the world works. Whether we look at jobs, trading patterns or global currency markets, China still shows up as a relatively small economy, and certainly not one that is driving the show, now or in the near future. Whether the peg stays or goes is a sublimely unimportant issue in the large scheme of things.
A longer version of this article was first published in the Far Eastern Economic Review; https://www.feer.com/.
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