Professional Adviser - China’s Currency Question
11 March 2010
Global financial markets have recently become fixated upon currencies in general, and the outlook for one in particular, the Chinese Renminbi. In this note, we discuss the outlook for this important currency, in the context of our assessment of the rather complicated macro economic outlook for the world’s largest emerging market economy and the implications of its development for the rest of the world.
If an investor looks at the attached chart of the Chinese currency versus the US$ over the past few years, one could be forgiven for assuming that we live in an era of economic stability. For long periods, this currency pair either flat lines or shows very steady changes. In reality, it masks important macroeconomic imbalances, and complex, increasingly politicised disagreements between two of the world’s major powers. This currency peg has become one of the most hotly contested discussion points at today’s global macro economic top table. Indeed, in some quarters there is a degree of hysteria surrounding the potential for an imminent decision by the Chinese government to alter their currency peg. However, when we look back at recent history, and study the present situation in China, it is far from clear that we should expect a major, or ‘maxi’, revaluation of the Renminbi.
China is widely acclaimed for possessing some US$2.4 trillion in foreign exchange (FX) reserves. At the same time, its low external debt to GDP ratio, a mere 6%, is impressive, and far from the levels that one would normally deem as being problematical. On the surface, China fares relatively well compared with its global peers, showcasing a strong balance sheet. When one scratches beneath the surface, however, one can see that in reality China has good reasons to require such a large reserve pool. It has an extremely large population to protect – roughly 1.3 billion people, and indeed an ageing population, likely to peak within the next decade or two. It is well known that China faces rather serious resource constraints, key examples being its shortages of oil, certain foodstuffs and iron ore.
A key driver of China’s large FX reserves is its large trade surplus with the USA. China, with its large pool of cheap labour, and following its entry into the World Trade Organisation in 2001, quickly became the global hub for low end manufactured goods. In fact, China’s relative productivity allowed it to take market share away even from countries as close to the US as Mexico, at least for manufacturing goods that do not require ‘just in time delivery’. After many years of macro economic underachievement, this surge in global trade has enabled China to become a force to be reckoned with.
Why has the exchange rate has been so stable in recent years, as shown in the chart? The reason is that China carefully controls its balance of payments; neither private nor public organisations have full freedom to trade in currency markets, as occurs in many other emerging economies for example. It is also easier when a country, such as China, has a large current account surplus and hence FX reserves to dictate the level of its exchange rate, and keep it from strengthening, than it is for a weaker country with a current account deficit, to prevent devaluation. The Chinese central bank has been able to sterilise such capital movements quite effectively, in order to retain control of its domestic monetary policy.
China has enjoyed the strong economic growth that has come on the back of many years of buoyant exports, helped by a cheap currency. Some commentators have even argued that it has become addicted to this model of economic development, an export led approach, choosing to use its strength and relatively closed capital accounts to impose an FX regime allowing only a minimal amount of strengthening over the past few years. Some US businesses have even claimed that China is a currency manipulator, although thus far the US government has not drawn this conclusion. China has argued, in turn, that currency stability helps the global economy during a difficult period. From mid 2005 to mid 2008, China did allow a gradual appreciation of its currency. However following on from the ‘credit crunch’ and post-Lehmans collapse, China resumed its policy of keeping its currency stable against the US dollar.
In recent weeks there have been more concerns amongst Western businesses and governments that China has not moved more quickly to a free floating exchange rate. Indeed, the US government has become vociferous in terms of calling for the Chinese government to move its currency towards a more market defined rate. Why, then, do the Chinese not simply allow their currency to float freely, and ‘play ball’ by normal international standards? The reason is that parts of the Chinese government are very concerned that the currency will rise too quickly if the currency peg was altered, to the detriment of the important export sector. In addition, the government does not want to be seen as weak, in terms of bowing to US demands.
Trends in the global economy may help however. There is evidence that Chinese exports are recovering more noticeably, not just to Asia but other developed economies as well. Exports were up sharply again in February, growing 46% pa and surpassing expectations. At the same time, Chinese GDP is recovering, with their data releases consistent with an economy growing over 11% pa in recent weeks. While much of this has reflected a major stimulus from the central government, the authorities are well aware they cannot keep spending at this pace and that at some point they will have to rely more on external demand to propel the economy. This ties in with another concern - the looming threat of inflation. Consumer prices fell for much of last year, though have returned to positive territory. There are concerns the Central Bank may find that its 3% CPI target for 2010 is not an easy task, as the economy gathers momentum and commodity prices pick up.
All in all, China walks a tightrope with a range of external and internal pressures. In some respects a currency move could be quite large; after all, the RMB is undervalued by some 20 to 30% vs the US dollar on some measures. However, history reminds us to be cautious, as the authorities try to ensure stability in the economy. Hence, when we look at what is priced in by investors, we can see that the market presently indicates roughly a 3% appreciation in the Chinese currency forwards market over the next twelve months. During the last period when China chose to move its currency, from 2005 until 2008, the Renminbi moved at a pace close to 6% per annum. Given the uncertainties over the global climate, it is sensible not to assume that China will bow to pressures, market or political, by moving their currency by a large amount. Their desire for macro-economic stability is a top priority!
The implications for financial markets in the rest of the world of a move in the RMB this year require careful analysis, as much depends on the extent and timing of any decision. A change in line with consensus investor expectations should, by definition, largely be priced into markets already. It could still prove a very mild positive for investors though, to the extent that it helps to partially alleviate some of the global macro imbalances. A move of greater magnitude should, of course, be correspondingly more positive. It can be portrayed, as China successfully rebalancing its economy. However it is imperative that any move is not seen as too big, and does not lead to investors worrying about a decision possibly derailing the Chinese economy. China is widely seen as a key driver of global growth at this difficult time, and preserving that macroeconomic vigour is of paramount importance for many markets.
Jason Hepner, Investment Director – Global Strategy, Standard Life Investments
This article was first published in Professional Adviser on Thursday 18th March 2010.
