RMB revaluation - the commodity peg scenario

This has become one of the most discussed and speculated topic.

The consensus is that revaluation is inevitable, and is only a matter of time.

But how will it be changed? There are a few scenarios:
a) widening the exchange rate gap, say, to 3%, 5%, etc. (widely viewed as the most likely)
b) artificial adjustment of the exchange rate (as done in (pre-)1994, arbitrary and invites speculation)
c) re-define the peg into a basket weighted by various currencies (e.g. include Euro, Yen, etc), such that at the date of change the two definitions yield the same valuation for the Yuan - not too different from what many countries were doing before the 1997 crisis . But the Singapore proxy is the most likely one, as China has good faith in Singaporean system. There will virtually be no change at the date of de-coupling (not to reward speculator), and the new basket will be weighted by China's trade (mainly import) volume.
d) re-define the peg in other ways - see below, the implementation will be similar to (c) above, no significant change in value at first, only shift of peg. "crossing the river stone by stone" (摸着石头过河).
e) let it float freely -- not too likely in near future, before the various banking problems are fixed

The Commodity Standard

Among these scenarios, a variation of (d) advocated by Stephen Ng Sheong Cheung in early 2004 (published in The HK Economic Journal) is particularly interesting. It is a redefinition of the peg, but not to the dollar, instead, to a basket of commodities, including oil, steel, corn, etc. The basket of commodities are chosen such that it represents, and is weighted by China's import of raw materials. The number of commodities should be chosen so that it includes the top 5-10 commodities, with a wide enough variety (e.g. to include food, fuel and metals). In theory, one can also add commodities/goods China exports as a negative weight element, though that would make the scheme more complicated.

This is essentially a variation of the Gold standard widely used in the world prior 1971 (the price of gold relative to its industrial application is way overvalued, compared with, e.g. silver or palladium), with some twists. The reasons this works include

  • The commodity portfolio represents China's import portfolio, so a change in commodity price will be reflected in the change in China currency. It saves importers in China the cost of hedging, hence saving business costs across factories in China. The hedging job will be up to the Central Bank, which needs to purchase the commodity futures or physical resources based on the estimated import demand. What it does is analogous to backing up the monetary supply with the commodity basket (rather than gold).
  • The scheme with a basket of commodities is a lot more feasible to implement today, vs pre-1970s, because it is a lot easier to calculate a complicated index and there is a much larger and more liquid market where one can trade today. Therefore, it is also easy for the Central Bank to hedge the commodities to back up the currency.
  • It makes the speculator's job a lot more difficult, because one then has to attack the whole range of commodities in the global market to attack the Yuan "peg". Oil price, e.g., is not easy to be manipulated by George Soros ,or even by George W Bush.
  • This scheme does not tie the interest rate (and hence the economy) in China to that of the US. So the economy in China will be allowed to go its own way. Instead, the scheme reflects the reality of China's needs in trading.
  • However, one should note that Central Bank "intervention" is still needed, because it has to stock up enough futures contract to "back up" the currency. I used quotation marks for "back up" because it is not really a "commodity standard" system and the bank notes are not fully (100%) backed up. Because RMB is still not fully exchangeable to a foreign currency, one only needs to back up the amount that is allowed to be exchanged. So this system is more difficult to maintain if the exchange is fully open.
  • An additional benefit is that by doing this one also automatically imposes certain disciplines in monetary supply, well, almost.

The caveats

  • Note this scheme is still artificial. What it does is to have the currency board (or Central Bank) trying to anticipate import demand. In a free floating scheme the value of a currency should be tied to the goods a country is exporting, instead of importing. e.g. Without a currency board the value for Kuwaiti and Russian currency should rise as the oil price rises, and Yuan would rise if the prices of clothes and furniture rise but fall if oil price rises. But there are reasons why the imported commodities are chosen even though it seems counter intuitive and requires a lot of intervention from the currency board. This will be explained later in the "implication" section.
  • While this system makes a lot of sense, except for the caveat above, for it to be applicable to other countries a true 'commodity standard' may be needed. e.g. The full backup is certainly doable for HK, where the Monetary Authority has enough cash to back up all issued notes. But it does not make too much sense as raw materials are not the crucial import for HK, and consumer goods do not have a good price reference as commodities
  • (edited to add) as pointed out by Brad sister, an interruption in supply (or miscalculation by the currency board) will make the management challenging and costly. Although the country has to pay the price when supply is interrupted, it should not be the currency board's responsibility to forecast the prices for import goods. But then is this worse than pegging to one single foreign currency?

The implications:

  • Speculator: RMB is not up for speculation. However, if China does pursue this option, the demand for commodity will be squeezed and a long position will likely to be a smart choice. The long on mining companies and currency in metal and oil exporting countries will also make sense. In fact, China will become a major force influencing the commodity prices, or competing for these natural resources, which is what she should have done regarding oil and steel many years ago
  • Chinese businesses (and foreign invested manufacturing facilities): the commodity prices will be a lot more stable in RMB, because now the price of oil and steel are synchronized with the RMB
  • The average Chinese people: their purchasing power does not change a lot when commodity prices change. The currency will be effectively appreciated.
  • George W Bush: there is no need bullying China to appreciate RMB, because by going into Iraq and failing to suppress oil price, RMB will be appreciated by definition. On the other hand, the only way to change the RMB valuation is by changing the commodity price it is pegged to. The good news for US is that USD and RMB are unpegged. The seeming "bad" news is that RMB will not be appreciated, since a continuity in valuation on the date of re-definition will be ensured.

In reality, a basket of Currency is more likely to be adopted first (too much risk as no one tried the commodity peg before and China does not have the expertise to manage complex financial derivatives). As China will be "crossing the river stone by stone" (摸着石头过河).

--- draft June 2nd


Sun Bin said...

p.s. another option to this commodity-pegging option is to create a buffer currency (sort of like Waihuiquan in the 1980's) which is fully exchangeable and fully backed by commodity futures.

Sun Bin said...

It turned out this idea is not new.

Terra project

Graham and Keynes' work in 1940s