Tuesday, 11 August 2015

Yuan Devaluation Signals Current Slump and Future Growth

On 11 August 2015, the People Bank of China weakened the yuan by almost 2 percent. The central bank’s move pushed the yuan´s “daily fix” to 6.2298 against the dollar, and that move was its biggest one-day change since China had loosened (somewhat) its dollar peg in June 2010. Financial market observers immediately jumped to two ´conclusions´:
·         While China´s central bank paid lip service to a more flexible exchange rate regime, it really signaled panic about China´s slowing growth;
·         The devaluation wasn´t a one-time shot but the likely entry to a prolonged period of engineering the yuan down to increase external competitiveness.
Consequently, all China-sensitive asset prices – such as oil, copper, shares of luxury brands and cars and emerging-market currencies – dived below their already depressed levels upon the devaluation news.
I will make the point that the market reaction and commentary is myopic: Even if the devaluation signals concerns about current growth, correcting the yuan´s accumulated overvaluation will be good for China´s growth, emerging countries´ growth as well as commodity and luxury exports.

Table 1: Yuan BIS Effective Exchange Rate, 01/2010 – 06/2015
2010 = 100

Some may still doubt that the yuan is overvalued. The evidence points to the contrary, though. According to the broad measure of BIS effective (trade weighted) exchange rate, the yuan has appreciated by some 30% over the past five years (Table 1). According to the Barclays behavioural equilibrium exchange rate model, the yuan remains the second-most overvalued currency in the world, by more than 20%[1]. The dollar’s recent ascent has pulled the yuan away from other currencies, leaving it increasingly overvalued, as the yen has stayed on a soft peg to the dollar. And even the Peterson Institute, traditionally the US Treasury´s ventriloquist to accuse China of unfair exchange-rate protection, has recently calmed down by gauging China´s so-called fundamental equilibrium exchange rate as ´correctly´ valued[2], at round 6 yuan per dollar. A further indication of yuan overvaluation is that the market and Chinese corporates had been expecting a yuan depreciation going forward: Onshore FX deposits surged in 2014, largely due to corporates holding more of their export proceeds in foreign currencies. Outflows recorded under the currency-and-deposits component of the balance of payments had also picked up, and forwards had been pricing in sizeable depreciation of the yuan versus the dollar.
Applying Dani Rodrik´s (2010) estimates[3] that a 10% nominal effective appreciation of the yuan would bring down China´s annual per capita growth by 0.86%, the 30% appreciation accumulated over the past five years may have chipped away some, 2.5% from China´s growth rate. This reduction in China’s growth has translated into a drop of GDP growth in poor countries (based on our former growth sensitivity estimates of 0.34 per cent)[4] by one percentage point of annual per capita income growth. The growth link between China and the emerging markets was even higher, with one percentage point of growth translating into 0.66% growth. These macroeconomic mechanics of growth can constitute a certain degree of growth optimism for China, the emerging countries, commodity prices, and world trade if China´s two percent devaluation in August is followed upon by the People´s Bank of China.

[2] William R. Cline (2014), Estimates of Fundamental Equilibrium Exchange Rates, November 2014, Policy Brief PB 14-25, November.
[3] Dani Rodrik (2010), ‘Making Room for China in the World Economy’, American Economic Review, Papers and Proceedings. Available at: http://pubs.aeaweb.org/doi/pdfplus/10.1257/ aer.100.2.89
[4] Garroway et al. (2012), ´The Renminbi and Poor Country Growth, The World Economy,
doi: 10.1111/j.1467-9701.2011.01408.x