Since late last year, some analysts have argued that the renminbi (RMB) is overvalued by as much as 30 percent. From a research perspective, this view not only fails to stand up to scrutiny, it is also casual analysis that abuses economic theory and ignores evidence.
RMB bears argue that overvaluation exerted deflationary pressure on the Chinese economy, as seen in the fall in product price deflation between mid-2001 and end-2012, without defining which price series they were referring to.
Let us look at the evidence. China’s consumer price inflation has remained subdued after 2011 but has not fallen into negative territory.
Deflation is seen in the producer price and corporate goods price indices (the latter tracks the former closely since both are upstream prices) only since late 2012. This is not consistent with the timeframe that the overvaluation camp is referring to.
I also highlighted this upstream deflation threat previously. The relevance to the RMB’s valuation is that upstream deflation lowers the cost base, making the RMB undervalued (not overvalued) under Beijing’s controlled currency regime.
The overvaluation critics also argue that China’s productivity adjusted for unit labor cost had risen sharply compared with that in the developed world, thus causing deflation in the Middle Kingdom. This directly contradicts their overvaluation argument, since rising productivity should result in undervaluation when the RMB is barred from appreciating in nominal terms.
We cannot find “product price” evidence supporting the overvaluation view. The correct understanding of the factors claimed by the overvaluation camp should be that upstream deflation plus rising productivity lead to RMB undervaluation, not overvaluation.
And upstream deflation in China is a result of international commodity price weakness and excessive domestic capacity but not so much a symptom of overvaluation, as the critics have claimed.
Looking at the current account, long-term capital flows and policy, I have argued in this column earlier with strong evidence that the RMB is still under mild appreciation pressure, albeit with rising trading volatility in the medium-term.
The bearish view ultimately comes from those analysts who blindly apply the purchasing power parity (PPP) theory to China’s exchange rate.
PPP states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent.
This means that a bundle of goods should cost the same in China, for example, and the United States once you take the exchange rate into account.
In essence, PPP estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency’s purchasing power.
Serious economists know there are complications, and controversies, with estimating PPP even for developed economies, such as the country’s CPI, consumption basket (which involves tastes and preferences), idiosyncratic factors including transport costs and taxes etc., and even its national income aggregation for comparison.
If the critics are struggling to understand, and trust, China’s data and system, how can they credibly estimate PPP?
The biggest assumption behind the overvaluation argument is an open capital account, which in our view will take a long time to evolve.
But the critics never say when they expect the capital account to become fully open for their view to materialise. They speak as if China’s capital account would be opened tomorrow and there would be massive capital outflows.
The fact remains that without free flows of capital, and with so many prices (factor prices, credit pricing, energy prices and taxes) distorted in China, it is impossible to calculate PPP properly.
All this means that even if someone was able to estimate China’s PPP and use it to argue that the RMB was overvalued, this would be nothing more than a wild guess, a “polluted’ view”.
Last but not least, PPP is a theoretical level that an exchange rate would take years to converge to; some exchange rates might never achieve PPP or might not reach it for longer than a year.
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