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Yuan close to fair value with capital outflows
By Alaistair Chan |
August 21, 2012, Tuesday
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Print Edition
Print Edition
CHINA is currently experiencing capital outflows. This suggests that the yuan is close to fair value. Continued outflows hamper monetary policy and could weaken the hand of reformists, potentially leading to the reimposition of capital controls.
There is growing evidence that the yuan is fairly valued against both the US dollar and a basket of major currencies. As such, continued yuan appreciation is no longer a one-way bet and there is the possibility of a sharp yuan depreciation in the event of a global financial crisis.
The yuan appreciated by 24 percent against the dollar in nominal terms from 2005 to the beginning of 2012, while in trade-weighted terms, which compare the yuan to a basket of currencies weighted by export share, it rose by 21 percent. In real terms, which accounts for inflation and wage differentials, yuan appreciation has been even greater, closer to 10 percent a year.
Continued yuan appreciation was for a time considered a one-way bet, and even from late 2008 to early 2010, when the People's Bank of China held the yuan steady, it was widely acknowledged that it would soon resume rising. However, the yuan's upward trend against the dollar stopped in 2012. Since the beginning of the year, the yuan has declined by 0.9 percent against the dollar, and yuan futures imply another 1 percent of depreciation over the coming 12 months.
Under normal circumstances, this would have raised global political tension, especially given the upcoming US presidential election and continued economic weakness in Europe.
Two reasons
There are two reasons why it has not. The first is that the Chinese central bank increasingly sets the yuan's value against a basket of major currencies, and the decline in the euro - it has fallen 4 percent against the yuan this year - means that the trade-weighted value of the yuan remains close to a record high.
The other reason is more worrying. China is experiencing substantial capital outflows that put downward pressure on the yuan and have prompted the central bank, which traditionally sells yuan to cap its value, to reverse course and sell dollars instead to stabilize China's currency.
Confirmation of this outflow came from China's second quarter balance of payments data, which showed US$71.4 billion in net outflows in the capital and financial account, outweighing a US$59.7 billion surplus in the current account.
Since the deficit on the investment account outweighed inflows from the trade surplus, the central bank made up the difference by selling foreign reserves.
The net deficit in the second quarter balance of payments (excluding reserves) was the first recorded since the full year deficit in 1998 - there may have been the odd quarter of deficit, but China began releasing quarterly balance of payments data only from 2010.
The State Administration of Foreign Exchange, which collects the data, felt compelled to comment that China "suffered a certain degree of capital outflow in the first half, but this does not suggest a massive retreat of foreign investment" and also that there was "no sign yet of capital flight."
This is true in the sense that China still saw positive net foreign direct investment, at US$38.6 billion in the second quarter, but this implies an even larger outflow of other forms of investment, most likely portfolio investment, suggesting an exit of speculative "hot money."
Boosting foreign investment
This also explains why the government has taken a variety of measures to boost foreign investment since April such as increasing quotas for foreign investment in the stock market and raising the maximum foreign ownership stake in securities firms.
The upshot is that while organizations such as the International Monetary Fund still consider the yuan moderately undervalued based on the trade surplus and other measures, the market thinks the yuan is near fair value.
This has a number of implications. Concerns about further outflows could give the government pause about lowering interest rates further, complicating monetary policy.
It also casts the government's so-far-unsuccessful efforts to boost the stock market in a different light. It was widely believed that these measures - cuts in trading fees, new initial public offering guidelines and a just-announced delay in new IPOs to avoid flooding the market with more shares - were to ensure a rising market when power is handed over at the end of the year and to placate retirees, who make up a large proportion of investors.
It now seems that the effort was also aimed at stopping investors from pulling money out of China, suggesting that the government is more concerned than it is letting on.
Whether liberalization continues or capital controls reappear amid fears of a financial crisis is an open question.
There is growing evidence that the yuan is fairly valued against both the US dollar and a basket of major currencies. As such, continued yuan appreciation is no longer a one-way bet and there is the possibility of a sharp yuan depreciation in the event of a global financial crisis.
The yuan appreciated by 24 percent against the dollar in nominal terms from 2005 to the beginning of 2012, while in trade-weighted terms, which compare the yuan to a basket of currencies weighted by export share, it rose by 21 percent. In real terms, which accounts for inflation and wage differentials, yuan appreciation has been even greater, closer to 10 percent a year.
Continued yuan appreciation was for a time considered a one-way bet, and even from late 2008 to early 2010, when the People's Bank of China held the yuan steady, it was widely acknowledged that it would soon resume rising. However, the yuan's upward trend against the dollar stopped in 2012. Since the beginning of the year, the yuan has declined by 0.9 percent against the dollar, and yuan futures imply another 1 percent of depreciation over the coming 12 months.
Under normal circumstances, this would have raised global political tension, especially given the upcoming US presidential election and continued economic weakness in Europe.
Two reasons
There are two reasons why it has not. The first is that the Chinese central bank increasingly sets the yuan's value against a basket of major currencies, and the decline in the euro - it has fallen 4 percent against the yuan this year - means that the trade-weighted value of the yuan remains close to a record high.
The other reason is more worrying. China is experiencing substantial capital outflows that put downward pressure on the yuan and have prompted the central bank, which traditionally sells yuan to cap its value, to reverse course and sell dollars instead to stabilize China's currency.
Confirmation of this outflow came from China's second quarter balance of payments data, which showed US$71.4 billion in net outflows in the capital and financial account, outweighing a US$59.7 billion surplus in the current account.
Since the deficit on the investment account outweighed inflows from the trade surplus, the central bank made up the difference by selling foreign reserves.
The net deficit in the second quarter balance of payments (excluding reserves) was the first recorded since the full year deficit in 1998 - there may have been the odd quarter of deficit, but China began releasing quarterly balance of payments data only from 2010.
The State Administration of Foreign Exchange, which collects the data, felt compelled to comment that China "suffered a certain degree of capital outflow in the first half, but this does not suggest a massive retreat of foreign investment" and also that there was "no sign yet of capital flight."
This is true in the sense that China still saw positive net foreign direct investment, at US$38.6 billion in the second quarter, but this implies an even larger outflow of other forms of investment, most likely portfolio investment, suggesting an exit of speculative "hot money."
Boosting foreign investment
This also explains why the government has taken a variety of measures to boost foreign investment since April such as increasing quotas for foreign investment in the stock market and raising the maximum foreign ownership stake in securities firms.
The upshot is that while organizations such as the International Monetary Fund still consider the yuan moderately undervalued based on the trade surplus and other measures, the market thinks the yuan is near fair value.
This has a number of implications. Concerns about further outflows could give the government pause about lowering interest rates further, complicating monetary policy.
It also casts the government's so-far-unsuccessful efforts to boost the stock market in a different light. It was widely believed that these measures - cuts in trading fees, new initial public offering guidelines and a just-announced delay in new IPOs to avoid flooding the market with more shares - were to ensure a rising market when power is handed over at the end of the year and to placate retirees, who make up a large proportion of investors.
It now seems that the effort was also aimed at stopping investors from pulling money out of China, suggesting that the government is more concerned than it is letting on.
Whether liberalization continues or capital controls reappear amid fears of a financial crisis is an open question.
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