Wen Jiabao

Fairly-valued yuan claim won't convince Wen's critics

PUBLISHED : Friday, 16 March, 2012, 12:00am
UPDATED : Friday, 16 March, 2012, 12:00am


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In a move guaranteed to make patriotic American politicians froth at the mouth, Wen Jiabao declared at his press conference the other day that the yuan was now fairly valued in the foreign exchange market.

Considering the view in Washington is that the yuan is about 30 per cent below its true value against the US dollar, it is worth taking a closer look to see if Wen's assertion stands up.

To support his claim, the premier noted that the yuan had appreciated 30 per cent in real terms since its 2005 revaluation, and pointed to the pricing of forward contracts in the offshore yuan market in Hong Kong.

'These show the exchange rate may have reached its equilibrium value,' he said.

First, it is true that the yuan has appreciated by 30 per cent in inflation-adjusted terms against a trade-weighted basket of currencies since 2005.

But since the Chinese economy has grown by more than 80 per cent over the same time period, while much of the rest of the world has been stagnant, Wen's critics in Washington can reply that if the yuan was undervalued in 2005, then it must be even more deeply undervalued today despite its appreciation.

Next, as the first chart shows, it is also true that yuan forward contracts in Hong Kong are now pricing in a moderate depreciation over the next 12 months.

But unlike Wen, few foreign exchange dealers suffer from any illusions that forward prices say anything significant about the yuan's fundamental valuation.

They simply reflect swings in supply and demand in what remains a relatively illiquid market.

Nevertheless, there are other indicators Wen could have pointed to. There are the recent outflows of hot money, which analysts at Mirae Asset Research estimate reached US$100 billion in the last quarter of last year.

And, notably, there is China's trade balance, which sank to a 10-year record deficit in February.

Now, one month's deficit does not tell us a great deal. But the broadest measure of China's trade balance, its current account, has shrunk from a surplus worth 10 per cent of gross domestic product in 2007 to just 2.7 per cent at the end of last year.

If a persistent current account surplus is evidence of an undervalued currency, as many in Washington claim, then Wen could surely argue that the evaporation of that surplus is a good indication that the yuan is no longer overvalued.

He could try, but his sternest critics would not be convinced. They would reply that China's current account balance is the amount by which its domestic savings exceed its domestic investment. As a result, the contraction of China's surplus in recent years simply reflects the increase in its domestic investment, not any marked revaluation in its currency. To support their claims, the Beijing-bashers prefer to look at more theoretical indicators of value, like the difference between the yuan's domestic purchasing power and the US dollar's.

According to the World Bank, back in 1981, 1.75 yuan bought the same quantity of goods and services in China as US$1 bought in the United States. At the time, the exchange rate was also 1.75 yuan to the US dollar. In other words, in 1981, the yuan was fairly valued.

Now take a look at the second chart. The red line here shows how the yuan's purchasing power has changed over the years. At the end of 2010, for example, it would have taken 4 yuan to buy in China what US$1 would have bought you in America.

But at the same time, the yuan's exchange rate, shown here by the black line, was 6.6 yuan to the US dollar. In other words, the yuan was undervalued by 40 per cent.

Now, there are all sorts of problems with this purchasing power parity rate as an indication of currency value, but none of them are going to deter the China-bashers from using it as an argument that the yuan is deeply - and unfairly - undervalued.

So, nice try, Mr Wen, but don't think you have silenced your critics.