Recently the Peoples Bank of China altered the way it determined the exchange value of the Chinese currency, the Renminbi (RMB). When the currency fell three percent in the first three days, fears proliferated of an intensifying currency war, a possible hard landing of the Chinese economy, and even pressures on the U.S. Federal Reserve to lifting interest rates from zero.
We believe all of these interpretations are wrong, stemming perhaps, from short-term market overreactions to dramatic news events. Our analysis paints a picture of a more flexible mechanism of exchange rate adjustment and a more resilient Chinese economy amidst structural change, which should not stand in the way of a gradual normalization of the interest rates by the US monetary authorities.
Firstly, the RMB pricing mechanism change is within the broad spectrum and overall design of the financial system reform in China, initiated two to three years ago by the new generation of Chinese leadership. These ongoing financial reform measures include, but are not limited to, interest rate liberalization, the Shanghai-Hong Kong stock link, allowing private and foreign banks to enter into Chinese financial markets, opening up the interbank market to foreign institutions (including foreign central banks), etc. In fact, the RMB exchange rate reform is somewhat behind the overall schedule and is largely aimed at catching up with other reforms measures that have already been implemented. It is thus a mistake to assert that the exchange rate reform is intended as a measure to boost exports, though at this time it could help somewhat in that.
Secondly, the Chinese economy is in fact much more robust than it appears in the conventional national accounts statistics, which are, after all, a legacy of World War II government technocrats. For example, labor costs in China are rising across the country and especially sharply in coastal factory areas. Also, the monetary stimulus (lowering official deposit rates and reserve requirements), fiscal expansion (infrastructure projects like high speed rail), and executive reforms (such as removing restrictions on establishing small and medium size enterprises – SMEs) packages enacted over the past two years are now kicking in after some lags. The collapse of oil prices in the past year also provides sustained positive feedback in the economy, amounting to billions, if not trillions of additional stimulus just like a gigantic tax cut. Finally, new apps and internet technology are changing the efficiency of household production and firm management in a dramatic fashion not yet easily reflected in the conventional GDP statistics.
Therefore, we firmly believe that, in the near term RMB/$ exchange rate may fall a bit —which, in our estimate, should be much less than 10 percent; but in the medium to long term, RMB will continue to appreciate due to the economic fundamentals. Markets are always efficient in the long run. Based on our calculations, China’s economy has likely reached its bottom in the 2nd quarter and will rebound in the 3rd or 4th quarter.
Thirdly, the structural adjustment of the Chinese economy will continue, despite the recent noise in the system, such as the stock market route and RMB devaluation shock. Exports and manufacturing will give way to consumption and services as the main drivers of the economy, as reflected by the last few quarters GDP numbers and August electricity usage. The story of investment may be more complicated, with more public expenditure on infrastructure from the central government replacing private companies and local government in the very near term. The structural adjustment will be gradual, but there will be no turning back.
More importantly, the RMB liberalization is intended to be coordinated with the liberalization of interest rates; otherwise there would be arbitrage back and forth. However, that does not necessarily mean that the capital account will or should be liberated at the same time, and the central bank – as the macroprudential regulator and financial stability care taker – may hasten, delay, or halt the opening of the capital account as it sees fit.
There is, accordingly, no need to worry about the capital flight from China. Both academics and central bankers have now realized that capital account opening must be accompanied by domestic micro foundations consisting of strong and healthy financial institutions. And China will gradually open its capital account as these domestic financial market reforms mature.
Last, but not least, the U.S. economy has been solidly on a recovery path and has seen 2 percent average GDP growth since 2009. Most Fed senior officials have recently expressed strong confidence in the robust performance of labor markets and many have maintained their support for the September rate lift. An advantage of sticking to this plan is to remove the huge cloud of policy uncertainly hanging over investors about how markets will respond to the rate hike. The remaining concern about how emerging economies will fare during the rate increase — China is not among the big concerns in my opinion — can be addressed by a gradual and slower pace in the interest rate normalization process. RMB devaluation should not be a drag on the Fed action plan.
As Nobel Laureate Robert Shiller shows, short run financial market responses to dramatic economic news, such as the Yuan devaluation, are usually excessive and overblown. But in the long run, financial markets come back to economic fundamentals. That’s why we do not need to worry overtly about the recent RMB exchange rate reform; if anything, it points to a better managed global financial system and a more resilient Chinese economy.