How much would the RMB peg drift

The Economist has an interesting discussion on what the RMB rate should be pegged at.

1. Big Mac index shows RMB is 59% undervalued
2. PPP shows it is roughly 40%
3. Economist using tools like FEER (Fundamental Equilibrium Exchange Rate)said it is 15-25%, with different assumptions some said it is 44% undervalued

Let's not believe any of them, otherwise PPP rate among freely floating currencies (EUR, GBP, JPY, USD) are exactly the same as forex rate. We all know this is not true (the ecnomists call this the Penn effect, with the Bis Mac being the most unconvertible but standized goods.). Market does not rest at the equilibrium point. The further apart the GDP/cap are, the further apart market is from the equilibrium, as we have observed. Capital control and soft environment also enlarge the "quantum" fluctuation.

There is a phenomenological study called BEER (behavioral Equilibrium Exchange Rate), according to Morgan Stanley and Goldman Sachs, RMB is only 5-8% undervalued (after the July 21st reval). I think this is what the rate will drift into in the next 36-48 months.

The duration of my guestimate seems arbitrary. But I have some reason for picking this range. My gut feeling is the annual adjustment in the peg itself should not be larger than 2.5-3%. Because, as cited in my previous post and Andy Xie of Morgan Stanley, the cost for exporters to hedge is around 3%, China needs to discourage this group from hedging on the derivative market. By limiting the annual appreciation, China helps the exporters save them some financial cost, and keep them from joining force with the speculators. Without demand from businesses, speculators are unlikely to succeed.

see excerpt below (for full content see the link at the top of this post)

Precisely wrong
Jun 23rd 2005

China's currency may not be as cheap as is commonly believed

FOR a decade, China's currency, the yuan, has been pegged to the American dollar at a rate of 8.28 yuan per greenback. Quite a lot of people—most vocally, some American politicians—think that the yuan is enormously undervalued, so that Chinese exports have an “unfair” price advantage in global markets. Earlier this year, a bill was introduced into Congress that threatens to impose a tariff of 27.5% on Chinese goods unless the yuan is revalued by the same amount. The Senate finance committee was due to hold hearings on the currency on June 23rd. If the figure of 27.5% sounds too precise to be believed, that's because it is: it is simply the mid-point of a range of estimates of undervaluation (15-40%) of which the bill's sponsors were aware. Estimating a fair value of the yuan is a dauntingly tricky business.
Usually, three pieces of evidence are offered to support the argument that the yuan is far too cheap. First, China has large trade and current-account surpluses. Second, the yuan's trade-weighted exchange rate has declined sharply since the dollar started to drop in 2002. And third, China's foreign-exchange reserves have surged in the past couple of years.

All this may suggest that the Chinese authorities have held the value of the yuan below its market rate. None of it, though, proves that the currency is unfairly cheap. On the first point, although China runs a large trade surplus with America, its total surplus is much smaller because it runs deficits with other countries. In any case, trade does not have to be perfectly balanced to be fair; a surplus may simply reflect differences in national saving and investment rates. On the second point, so what if the yuan's trade-weighted value has fallen since 2002? It rose—and more markedly, at that—between 1994 and 1998. And last, the build-up of reserves is not proof of unfair currency intervention, because much of it is the consequence of flows into China of speculative money betting on a revaluation.
For any discussion of the “fair” value of a currency, that value first has to be defined. The oldest theory for doing this is purchasing-power parity (PPP): the idea that, in the long run, exchange rates should equalise the prices in any two countries of a common basket of tradable goods and services. The Economist's Big Mac index is a crude estimate of how far market exchange rates differ from PPP. Our latest index shows that a Big Mac costs 59% less in China than in America—ie, that the yuan is 59% undervalued against the dollar. More sophisticated estimates of PPP, based on traded goods, imply a smaller figure of around 40%.
A second approach is to estimate the fundamental equilibrium exchange rate (FEER). This is the rate consistent with both external balance (meaning a sustainable current-account balance) and internal balance (ie, full employment with low inflation). Working this out requires some idea of China's sustainable current-account balance. Many economists argue that because China has a relatively high return on capital, it should be a net importer of capital—ie, it should run a current-account deficit, not a surplus as it does now. A study by Virginie Coudert and Cécile Couharde, published earlier this year by CEPII, a French international economics institute, estimates that, if China is assumed to have a sustainable current-account deficit of 1.5% of GDP, then the yuan is 44% undervalued against the dollar. A study last year, by Morris Goldstein, of the Institute for International Economics, in Washington, DC, which uses a similar method, suggested an undervaluation of 15-25%.
Hold on: what about internal balance? A problem with many FEER studies, says Stephen Jen, an economist at Morgan Stanley, is that they assume that China is close to internal balance. That is hard to square with 400m underemployed rural workers waiting to shift into industry. Even if external balance requires a big revaluation, the internal-balance criterion may partially offset this, because a lower exchange rate would help to bring underemployed resources into use. And there is another flaw in the FEER studies. The claim that China should be running a current-account deficit assumes that net capital inflows will continue. But if China liberalised capital flows, these could be reversed as firms and households invested abroad in order to diversify their assets. The sustainable current-account balance might then be a surplus, not a deficit.
Beneath the froth
More fundamentally, Mr Jen is unhappy about defining a currency's fair value as that corresponding to a “sustainable” current-account balance. That is a less useful guide in a world of increasingly mobile capital. He prefers a third method, known as the behavioural equilibrium exchange rate (BEER). Under this method, economists establish which economic variables seem to have determined an exchange rate in the past (as well as having some theoretical basis), and then plug in the current values of those variables to estimate the equilibrium rate.
Econometric tests imply that the most important determinants of the yuan's real exchange rate have been China's productivity growth and budget balances relative to other countries', and its net foreign assets. Using this model, Mr Jen finds that the yuan is currently only 7% undervalued against the dollar. Economists at Goldman Sachs, using a similar approach, reach a similar conclusion: the yuan is 10% too cheap.
Using a range of yardsticks, the International Monetary Fund reckons, like the BEER studies, that it is hard to find strong evidence that the yuan is much undervalued. The uncertainty about fair value explains why the IMF and America's Treasury prefer to say that the yuan needs to become more “flexible” than to call for revaluation outright. It is certainly in China's long-term interest to make its exchange rate more flexible. But calls for a revaluation of 27.5% rest on flimsy foundations. The economics of exchange rates are rarely so simple.


Anonymous said...

The IMF has a long history of wimping out on exchange rate issues, and it did so again (in my view). If they could not decide china and malaysia are undervalued, they lack credibility. if not them, then who?

they also wimped on argentina in 00/01 -- they were unwilling to say that convertibility (peso peg to $) was unsustainable, or that argentina's currency was overvalued.

I may be a bit too adament on this, but China has a 5% plus CA surplus, and attracts 3% of GDP in FDI --that to me is pretty strong evidence of an undervaluation (along with China's huge export growth).

in any 2.5% per year probably does not keep up with productivity differentials, so china's competitiveness vis a vis the US keeps growing. Further real exchange rate adjustment would be needed whether through inflation in China or deflation in the US. And more concretely, that small change almost assures the resurgence of US protectionism ...

2.5% may avoid incentives to speculate, but i don't think it addresses the basic problem.

Sun Bin said...
This comment has been removed by a blog administrator.
Sun Bin said...

Yes, i know 2.5% p.a. is not enough. Neither was 0% in the past 2.5 years. I was just stating what I believe will happen.

China can even keep it unchange, if they want, at a cost. If they let some of the steam out of the pot, the pressure is partially released. 2.5% is what I believe they would let go. By moving at below 2.5%, they can yield to market pressure and discourage speculator at the same time.

Regarding productivity differentials, isn't this what China wants? Reval but maintain the same productivity differentials?

NDF market predicts
It seems unlikely for China to move at the NDF number.

Sun Bin said...

I think there are a few different issues here

1. Current RMB XR is not at the equilibirum point, not is it at where free market would trade - this we all agree
2. Maintaining the peg means the departure from the eq. point will become even larger as productivity differentials widen

Now there are 2 fixes.
1) prevent it from drifting further
2) bring it back to the eq. point

I think the Chinese are only interested in (1). We will not see (2) for the next 3-5 year, or even longer.

Moving to a basket peg is the first step for achieving (1), slowly drifting, e.g. 2%/yr, of the basket peg will be an additional step. But it seems quite unlikely for them to move further in the near term.