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Risks in the CDO Market

The Undervaluation of the RMB

Brad Setser:

RGE - The Economist still isn't convinced the RMB is undervalued ...:Half a trillion dollars apparently doesn't get the respect it used to. Neither the author of last week’s Economics Focus column nor Morgan Stanley’s Stephen Jen think that the Chinese yuan (or RMB) is undervalued, despite annual reserve growth that would have been around $350b last year but for $100b or so of debt purchased by Chinese state institutions and that could approach $500b this year. The Economist, for all its free market barnstorming, apparently doesn’t mind massive government intervention in the foreign exchange market – intervention that necessarily means governments will be big players in a host of asset markets.

Indeed, it often seems that the larger China’s current account surplus (it looks set to rise above 12% of China’s 2006 GDP), the faster China’s reserve growth, the faster Chinese exports growth (30% y/y in the latest data) and the more net exports contribute to growth (2-3% of GDP in q1, about the same as in 2006), the more the Economist (and, to be fair, some economists) insists that China’s exchange rate isn’t truly undervalued. 

The Economist includes many different voices. This week's leader on the lessons from the 1997 crisis includes a welcome call for China to let its exchange rate move more.  But I think it is fair to argue that its main editorial line consistently has emphasized that the RMB isn’t obviously undervalued even as China's trade surplus soars -- while suggesting that other currencies (the Saudi riyal, the Japanese yen) are....

[R]ather than encouraging China to mark the RMB to market, the last week's Economist argues we should all mark the RMB to a model, and specifically to a behavioral equilibrium exchange rate model.   Fair enough.  But marking-to-model poses its own risks, not the least the challenge of picking the right model.  I cannot quite figure out what a behavioral equilibrium exchange model tells us about the currency of a country that manages its exchange rate as heavily as China.   Movements in China’s real exchange rate clearly have been shaped more by central bank policy – notably the dollar peg – rather anything else. 

The behavioral equilibrium exchange rate approach – at least as I understand – says that it is impossible to determine whether an exchange rate is under or over-valued based on macroeconomic fundamentals, so it is better to instead to try to find variables that help explain how the country’s real exchange rate has moved in the past:  "This [approach] does not attempt to define long-term economic equilibrium. Instead it analyses which economic variables, such as productivity growth, net foreign assets and the terms of trade, seem to have determined an exchange rate in the past, and then uses the current values of those variables to estimate a currency's correct value."

Given China’s policy decision to peg to the dollar, though, the variable that will appear to drive movements in China’s real exchange rate will be the variable that moves when the dollar moves. If a weaker dollar leads to higher net foreign asset growth (because it produces a weaker RMB), the model might argue that the even higher foreign asset growth implies an even weaker RMB....

I do not doubt that determining whether or not a currency is misaligned is difficult – and different models produce different results.  But some cases are easier than others.  $500b [a year] in intervention does provide a bit of a clue...