Two ways currency experts are wrong about the yuan

In contrast to analysts' views, China's currency is actually sharply overvalued in real terms. Nor is Beijing loosening its capital controls

PUBLISHED : Tuesday, 03 September, 2013, 12:00am
UPDATED : Tuesday, 03 September, 2013, 4:13am

Ask currency analysts about the yuan, and the chances are they will tell you two things.

First, they will say that despite appreciating 35 per cent against the US dollar over the past eight years, China's currency is still undervalued.

Second, they will tell you that in their determination to internationalise the yuan, policymakers in Beijing have been busy dismantling China's remaining capital controls, and that for most intents and purposes, the currency is now freely convertible.

They are wrong on both counts.

Working out what a currency's fair value should be is notoriously tricky. The most common method economists use is to say commoditised products - like a can of Coca-Cola or a Big Mac hamburger - should cost the same in every country. Then they see how much market exchange rates deviate from this reference price.

By this purchasing power parity method, the yuan does indeed look excessively cheap. According to the World Bank, on this measure the yuan was undervalued by 34 per cent last year. A more up-to-date estimate puts its undervaluation at 30 per cent.

But there are problems with this method of valuation. Notably, it fails to take into account that stuff really ought to be cheaper in developing countries than in the rich world.

Not only do China’s controls on capital flows remain in place, they are as effective as ever

In response, analysts have attempted to come up with other, more accurate, valuation measures. One compares real exchange rates, which take inflation into account, adjusted for differences in per-capita incomes. Others factor in trend exchange rate movements, interest rate differentials and risk premiums.

Apply these methods, and the yuan's undervaluation disappears. According to one recent academic study, at the end of last year the yuan was actually between 10 and 20 per cent overvalued.

It's not only academics who think the yuan is looking expensive. A handful of investors have recently come to the same conclusion, arguing that the combination of exchange rate appreciation, wage inflation and declining productivity growth means the Chinese currency has now become sharply overvalued in real terms.

Anecdotal accounts of accelerating hot-money outflows over recent months would appear to support that view.

But again there is a problem. Despite endless talk of Beijing loosening its restrictions on yuan convertibility, China retains heavy controls over capital flows into and out of the country.

If Beijing had really relaxed its capital controls, then financial traders would rapidly take advantage of any yield differential, hedging out their exchange rate risk and arbitraging the difference between yuan and US dollar interest rates.

As a result, any significant relaxation of capital controls would soon see the yuan and the US dollar move towards what is called covered interest parity. In a nutshell, assets of similar risk would trade at similar yields, once exchange rate risks had been eliminated.

But that isn't happening. According to a study published last week by the Bank of Finland's Institute for Economies in Transition, "there is no evidence that the [yuan's] covered interest differential is shrinking over time".

In other words, not only do China's controls on capital flows remain in place, but that they are as effective as ever.

"Despite the ongoing process of integrating with the rest of the world and the proclaimed efforts of liberalising its capital account, our results affirm … that China retains its abilities to restrict cross-border financial capital-market movements," conclude the report's authors.

"The policies on capital controls are substantial and binding. Apparently, China still considers capital control policy an indispensible tool to manage and stabilise the economy."