How Undervalued is the Yuan?
Today’s news that the Chinese Central Bank is still managing the value of the yuan is a good excuse to revisit the issue as to whether the yuan is significantly undervalued. Senator Lindsey Graham has been claimed that the yuan is undervalued by at least 15% and by as much as 40%. His claim appears to come from the 2004 Report to Congress of the U.S.-China Economic and Security Review Commission (June 2004). For example, page 4 of this report reads:
A key factor contributing to the U.S. deficit with China is the undervaluation of the Chinese yuan against the U.S. dollar. This gives Chinese manufacturers a competitive advantage over U.S. manufacturers. Economic fundamentals suggest that the Chinese yuan is undervalued, with a growing consensus of economists estimating the level of undervaluation to be anywhere from fifteen to forty percent.
In the recent Roubini v. Altig debate, Nouriel stated:
If China were to liberalize its capital account regime – on capital inflows as much as on capital outflows – and stop intervening, the Chinese currency could appreciate by more than 20%, minimum.
In the overall scheme of things, if you put any faith at all in markets’ ability to provide best guesses of such things, the expected magnitude of RMB-appreciation looks pretty moderate. By the last update I received, non-deliverable forward foreign exchange contracts were suggesting a total appreciation of about 8% over the next twelve months. That includes the 2% today. This is up a bit from yesterday, when 6% was the bet, but it still doesn’t add up to great drama.
We shall discuss below why David’s evidence may not be a good measure of how undervalued the yen is.
Brad Setser has been hinting that I should read On the Renminbi: The choice between adjustment under a fixed exchange rate and adjustment under a flexible rate by Jeff Frankel. This paper has a very nice discussion of the pros and cons of fixed versus floating exchange rates. Frankel discusses the Balassa-Samuelson relationship and gives reasons to believe that the yuan is approximately 40% undervalued. And as I think of David’s forward rate evidence, this comment is intriguing:
Few economists would seriously recommend a revaluation over a short period of time of the yuan on the order of magnitude suggested by this interpretation of the Balassa-Samuelson equation. In the first place, a sudden revaluation of the currency of this magnitude would be disruptive. In the second place, other considerations matter in addition to the Balassa-Samuelson regression, including current monetary conditions.
David’s forward rate evidence suggests the market’s expectation of yuan appreciation is less than 10%. Suppose the market assigns a very small probability (say 10%) to the Chinese Central Bank letting the yuan appreciate significantly (say 40%) and a large probability (say 90%) to a modest revaluation (say less than 90%). David’s evidence would be consistent with the results derived from the Balassa-Samuelson relationship.
With a hat tip to Mark Thoma, the recent comments from
Joseph Stiglitz provide a nice way to close this post. Stiglitz – like Frankel – provides a good argument why freely floating exchange rates are not necessarily the optimal currency regime. We can, however, imagine a significant revaluation of the yuan without resorting to a freely floating exchange rate. For example, the UK Central Bank significantly devalued the pound in 1967 without abandoning Bretton Woods – although this exchange rate regime was abandoned later. Stiglitz is correct that a yuan revaluation would have only a modest impact on the U.S. current account deficit. He is also correct to note that this exchange rate issue is just one of many policy considerations facing both China and the U.S.
Update: Is Donald Luskin trying to deny the premise that the Chinese Central Bank is pegging the yuan/$ exchange rate? If so, he truly is clueless. If not, could someone explain to me what his latest rant is all about?
Update II: I left out the how fast and how far debate – but it seems that Louis Uchitelle had already filled this void (with hat tip to Brad DeLong).
Update III: David Altig adds to the discussion. As you might tell from my comment to his post, I agree with his latest.