'Liconomics' could mean a weaker yuan

After climbing by a third against other currencies in inflation-adjusted terms, the yuan may have overshot and could be seriously overvalued

PUBLISHED : Friday, 28 June, 2013, 12:00am
UPDATED : Friday, 28 June, 2013, 5:06am

With Premier Li Keqiang just over 100 days in the job, investors have concluded that he is serious about pressing ahead with financial reforms.

That means economic pain in the short term, with growth set to slow as Li attempts to curb China's runaway credit creation.

Many private sector analysts now expect gross domestic product to expand by less than 7.5 per cent this year. If they are right, it will be China's weakest economic performance since 1990.

With corporate profit margins already squeezed, slower growth is sure to hurt, one reason why Chinese stock prices are down by 13 per cent over the year to date.

But there are things the authorities can do to sweeten Li's bitter medicine. For example, they could alleviate some of the pain by weakening the yuan's exchange rate.

It would be a contentious move. Although the yuan has appreciated by a third against the US dollar since its June 2005 revaluation, most international observers believe the currency is still well below its fair value.

In April the US Treasury called the yuan "significantly undervalued". Then, in May, the International Monetary Fund declared the yuan "moderately undervalued relative to a basket of currencies".

Yet economists have been calling for yuan appreciation for so long now, they may have missed something: after climbing by 34 per cent in inflation-adjusted terms against a broad basket of other currencies since 2005, it is likely that the yuan has overshot, and that it is now considerably overvalued.

There is some good evidence that the yuan is now too strong for China's economic health. For one thing, there is China's deflation problem.

Deflation does not show up in consumer prices, which rose 2.1 per cent in the 12 months to May.

But as Charles Dumas, chairman of the economic consultancy Lombard Street Research, points out, with consumer households making up just 36 per cent of China's gross domestic product last year, consumer prices are not the best measure of economy-wide inflation.

With industrial output equal to almost 50 per cent of GDP, Dumas prefers to look at producer prices. And China's producer price index has now been in negative territory since early last year, falling 2.9 per cent in the 12 months to May.

As a result, real interest rates are relatively high, at almost 10 per cent, which makes it hard for companies to invest profitably.

At the same time, with labour costs rising faster than productivity growth, China's competitiveness is declining, putting a further squeeze on profits.

"At some stage the government will need to mitigate the upcoming weakness of the economy by devaluation, even if the authorities are hanging tough for the time being," Dumas argues.

Others are coming round to a similar view. Yesterday, analysts at Barclays warned that Li Keqiang's economic reform agenda, dubbed Liconomics, "could point to further downside risks for both economic growth and asset prices, including the exchange rate".

Of course, steering the yuan lower would be a deeply unpopular move with China's trading partners and competitors, especially the United States and Japan.

Yet there is one way Li could both weaken the yuan and avoid criticism. He could relax Beijing's controls on capital outflows, granting China's savers greater freedom to invest abroad.

That does not look a likely move right now. Sizeable capital outflows could destabilise China's already shaky domestic banking system.

But with many analysts believing that Beijing will have to recapitalise its state-owned banks at some point anyway, Li may just conclude that he has little to lose, and much to gain, from a weaker yuan.