Exclusively from Michael Pettis’ newsletter:
First, and most obviously, the RMB is not overvalued. Looking at just the change in the value of the currency over some period is meaningless because China’s export competitiveness is based as much on low wages and cheap financing as it is on an undervalued currency, but in any “normal” world, in which China was growing at 7-8%, unemployment was low, and debt rising, while the rest of the world was barely growing, and was deleveraging amidst high unemployment, China should be running a huge deficit while the rest of the world ran a huge surplus. This is just basic trade economics. That China is still running a large surplus indicates just how distorted the reality is.
More importantly, however, is the rebalancing process. Depreciating the currency will not increase household income. It will raise the cost of imports, including energy and food, and so reduce the real value of household income.
…What is more, by reducing household income while boosting the tradable goods sector, devaluation will force up China’s already too-high savings rate. The idea that a depreciating RMB will make Chinese spend more because they will benefit from a wealth effect as their foreign assets appreciate in value assumes that ordinary Chinese already own a huge amount of foreign assets. They do not. If there is any positive wealth effect it will only affect the already-rich, for whom additional wealth has very little impact on additional consumption.
If the RMB were to depreciate we would need even higher wages or interest rates than we otherwise would in order to force up the household income share of GDP, and I think it would be a huge mistake to sacrifice the interests of both the capital- and labor-intensive sectors in order to make life easier for the tradable goods sector. We need more service industries and high-tech industries in China, not more toy manufacturing.
But perhaps the strongest argument for the PBoC is the capital flight argument. I suspect the only thing keeping net inflows into China so positive is the carry trade, in which higher relative interest rates and the expectation of continued appreciation causes Chinese companies to bring (often illegally) large amounts of money into the system (of course at the expense of the PBoC, who must carry the other side of the trade).
All this inflow isn’t a good thing, of course, but once you kill the carry trade, the risk is for an enormous outflow of capital that could devastate the banking system. Of course the net inflows into the system are also destabilizing in that they lead directly to the problem of over-investment and asset bubbles, especially in the real estate sector. The PBoC should, and would like to, move gradually to stop the inflows, but to switch from an appreciating regime to a depreciating regime, besides causing fury among China’s trade partners when China can least afford a trade fight, risks a very sudden reversal of capital flows which the bank system would be unable to absorb.
