The End of the Run for the Yuan?

In a few years’ time, it is possible that we could well see the Chinese yuan return to the kind of relative obscurity (at least by large country standards) that it so richly deserves -- an emerging markets version of the Japanese yen.

It is not an exaggeration to say that the yuan has been one of the biggest economic issues to come out of the emerging universe in the past decade. It is difficult to think of another topic that cuts across so many different lines including politics, market investment strategy, structural development debates and international relations – starting with fears that China was unfairly distorting global trade and growth through a massively undervalued exchange rate, and ending with the idea that the yuan is now destined to topple the US dollar as the world’s reserve currency.

Attention has been based on four key macro trends: an extraordinarily high trade surplus, rising global market share in virtually every export category, steady, almost guaranteed trend yuan appreciation, and the rapid policy-led opening of offshore trading.

The fun is now winding down. Each of these trends is now likely coming to an end – which, in turn, implies the end of the Great Yuan Trade.

This doesn’t just mean the end of one-way yuan appreciation – although that change is indeed looming on the horizon – but also the end of the Chinese currency as a an important topic that dominates the attention of US congressmen, global reserve managers, academics and conspiracy theorists everywhere.

The End of Surpluses and Market Share

The bottom line is simple: China’s current account surplus is slowly but surely disappearing. It is already well under the “Geithner threshold” of 4 percent of GDP that constitutes a structural imbalance according to US Treasury guidelines, with no real sign of any turnaround over the past 12 months. We understand that past performance is no guarantee of future trends, but there are at least three good arguments why the trade balance is not going to rebound sharply any time soon.

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First, there has been nothing close to a global recovery that would lead to sustained strong double-digit trend volume export growth to developed markets, and we don’t expect such a vibrant scenario going forward.

Second, there is little indication from China’s macro data that excess domestic capacity is pushing the surplus higher from the supply side – and this is after many quarters of policy tightening and weak demand.

Third, with local unskilled wages exploding upwards, China is already losing market share in traditional manufacturing export industries such as toys, textiles, footwear and sporting goods. Mainland firms are still gaining ground in higher value-added sectors such as IT electronics, of course, but the days of China eating everyone’s lunch are clearly over.

We do not expect the trade balance to go careening into serious deficit, however, for the simple reason that the government is not easing policy today and shows no interest in stimulating the economy a la 2008-09. Indeed, we expect the most import-intensive parts of local demand such as construction and infrastructure spending to remain flattish for much of 2012.

All of which means that the political noise over Chinese external imbalances, unfair currency practices and exchange rate manipulation will probably continue to fade from here. The yuan is no longer under major strengthening pressure and it should come as no surprise that the exchange rate has traded essentially flat against the US dollar since the beginning of the year, with an unprecedented magnitude of two-way trade as well. We don’t mean to say that the yuan can’t appreciate moderately. But it is increasingly clear that this is no longer a unidirectional trade with guaranteed returns.

Could we actually see the currency depreciate sharply from here, as some bears would have it? Not really. To begin with, as we argue, domestic demand is simply not strong enough to push the trade balance into sizeable deficit any time soon.

Moreover, the popular idea that China is threatened with a potential flood of portfolio capital outflows is sorely misguided. Any top-down measure of implied “hot money” inflows shows that there haven’t actually been any over the past few years, at least not on a sustained basis in any significant magnitude (Chart 4 above). Which leaves relatively little to go flooding back out again. And need we even mention the US$3 trillion-plus pile of official FX reserves?

The bottom line is that (i) there’s precious little chance that the yuan will be anything but a heavily managed currency going forward, and (ii) it is likely to be far more range-bound as well – some upside, perhaps some downside, but no real drama.

The end of liberalization?

We would feel differently, of course, if we thought that China was on the verge of dramatic capital account liberalization that would open the doors to far larger portfolio movements. This would not only make exchange rate trading a more exciting proposition, it could also push the yuan onto the global stage in a much bigger way and provoke a longer-term shake up of international portfolios.

There’s just one problem: it’s not happening.

There are three key points to make here. The first is that despite the rapid development of the offshore Hong Kong “CNH” market over the past few years, there has been no corresponding opening of the onshore market.

How can we tell? As regular readers know, there is a quick and easy way to measure the effectiveness of cross-border flows in any economy: simply compare domestic short-term interest rates with the interest rate implied in the internationally traded FX forward market.

Chart 5 below shows the behavior of the two rates series for China’s more open neighbors, including Korea, Malaysia, Singapore and Taiwan. As you can see, they are extremely close at any point in time, indicating a high degree of capital mobility and thus close arbitrage.

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Although Hong Kong deposits may sound like a significant figure, this is still a tiny, even imperceptible drop in the bucket in terms of global financial markets.

Nor, finally, do we expect the government to follow through to the logical conclusion of its offshore yuan experiment, i.e., the integration of local and overseas markets through a more radical liberalization in the near future – or anything even remotely close to it. Despite some of the political rhetoric coming from leadership circles, it’s not just that they “won’t” open the capital account ... in a very real sense they can’t, at least not fast enough to matter.

For more than two decades the entire philosophy of monetary management and financial system development has been based on a closed-economy system: maintaining low and stable interest rates without having to worry about external arbitrage; breezily adopting economic stimulus when needed without concern about underlying banking system asset quality; propping up banks with historically high NPL ratios and fixed-cost pricing, and keeping iron-clad control over the value of the exchange rate. All of these only work when foreign portfolio funds cannot influence asset prices, and when locals have nowhere else to go

And although it may be very much in China’s theoretical interest to move to a more open and market-driven system over time, it is certainly not in policymakers’ interest to jump-start the reform process at a time when the economy is overextended with credit, banks are facing another wave of bad loans and the government is in the middle of trying to slow the economy without causing an undue shake-out in sensitive property markets.

That is, they are bound to get around to external liberalization at some point, but it certainly isn’t happening today and won’t really be happening tomorrow. So in the meantime get ready for the new, more obscure Chinese yuan.

(Jonathan Anderson, formerly the chief emerging markets economist for UBS, is now an independent emerging markets consultant.)