Do Markets Determine The Value Of The RMB? by Michael Pettis’ China Financial Markets
Last Tuesday the PBoC surprised the markets with a partial deregulation of the currency regime, prompting a great deal of discussion and debate about the value of the RMB. Part of the discussion was informed by a consensus developing in one part of the market that the RMB is no longer undervalued but is in fact overvalued. Why? Because if left to the “market”, that is if the PBoC stopped intervening, the excess of dollar supply over demand would force the RMB to fall.
This argument is based on a pretty confused understanding of how markets work and why investors do what they do. I thought it might be useful if I were to try to lay out the issue a little more clearly, and along the way address related issues. Because it isn’t necessarily easy to tie all of the topics together in an essay, I thought it might be better if I put it in the form of a series of questions.
There are two conclusions, or at least two points I would argue:
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- “Market” forces, that is the balance of supply and demand, do not always indicate the relative valuation of an asset. This is partly because there are several ways to define market forces, but mostly because we usually think of valuation in terms of economic fundamentals. An overvalued currency is one in which market fundamentals, by which I mean the valuation of assets on the basis of expected cashflows discounted at an interest rate that is not distorted, drive supply and demand.
- Supply and demand for an asset can also be driven by what traders often call “technical” factors. These are generally changes in supply in demand caused by other than fundamental factors. When China first approved the QFII program that permitted foreign investors to buy stocks, for example, or had China’s stock markets been included in the MSCI global benchmark in June, as was expected, there was or would have been an immediate increase in demand for Chinese stocks that would have caused prices to rise for reasons that had nothing to do with an improved economic outlook.
When I was a student, I was taught that if prices did rise, they would do so by an imperceptible amount because they had been trading at a level consistent with a fundamental balance between demand and supply, and as soon as foreign purchasing caused prices to increase, Chinese investors would take advantage of “excessively high” prices to sell out. Of course this is almost the opposite of what happened. Prices rose precisely because of expected buying, and then fell in the case where the buying materialized.
There was no fundamental valuation to anchor prices. Once I became a trader this was one of the many things I had to unlearn, but rather than reject altogether the idea that fundamental valuation plays any role, which too often is the reaction traders have when they first learn that markets are not always driven by value, I thought it would be more useful to identify the conditions under which market prices do or do not respond to fundamentals.
- The RMB almost certainly would decline in value today without PBoC intervention, but this does not indicate at all that the RMB is overvalued. In fact the best argument is that the market is driven largely by technical, and that if we try to extract information from fundamental markets, we almost certainly would arrive at a very different conclusion. The RMB, it turns out, remains undervalued, although I suspect not by very much.
How did the PBoC change its currency regime?
The PBoC’s statement on August 11 that it was changing the country’s currency regime set off an explosion of analysis, accusation, praise and questioning that hasn’t yet subsided much. Along with devaluing the currency by 1.86%, the most since 1994, the PBoC announced that it would modify the way it set the reference rate, known as “central parity”, that determines the RMB’s trading band, and it would so so “for the purpose of enhancing the market-orientation and benchmark status of central parity”.
It has, in effect, partially deregulated the exchange rate mechanism by relaxing intervention procedures, although it is still able to intervene as much as ever. Effective August 11, the PBoC said, the central parity would be set on a daily basis equal to “the closing rate of the inter-bank foreign exchange market on the previous day.” Probably to indicate that this did not mean the end of PBoC intervention, it added that the rate would be set “in conjunction with demand and supply condition in the foreign exchange market and exchange rate movement of the major currencies.”
Until that day the PBoC set central parity every day at whatever rate it thought appropriate. In principle this is supposed to mean that the value of the currency is a function of the PBoC’s best estimate of the exchange rate that maximizes China’s long-term productivity. In the best of cases, however, the sheer complexity of any economy, let alone the global economy within which it operates, would make this impossibly difficult to determine even if there were objective ways of valuing the choice between a short-term cost or benefit and a long-term cost or benefit, or of choosing how costs or benefits will be distributed among different economic sectors or social groups.
This is why there is a grudging consensus, although certainly not unanimous (nor is all the consensus grudging), that the most effective and efficient way to determine the exchange rate is to let the market decide. If all potential buyers and all sellers of RMB, whatever their reasons, collectively decide on a price at which all transactions can clear, that price is presumably the best estimate of the exchange rate that maximizes China’s long-term productivity.
Why did they do it?
There are three different reasons that might explain the PBoC’s move Tuesday.
- Improve trade. While China’s current account surplus has been very high, this is mainly because imports have done worse than exports. Both have fared poorly. The numbers were especially bad in July, when imports were down 8.1% year on year while exports were down 8.3%. Because of its peg to the appreciating dollar, the renminbi has been very strong on a trade-weighted basis. The new currency regime may be aimed at reversing this.
- Qualify for SDR. There may have been concern that the large and persistent gap between the fix and actual trading in both the onshore and the offshore markets would prevent the RMB from qualifying for inclusion in the SDR basket. What is more, by including a RMB pegged to the dollar, the already overly dominant weight of the dollar in the SDR would be substantially increased, something the IMF clearly does not want. Beijing may be eager for the RMB to become part of the SDR basket because it believes this will result in significant foreign inflows that will help reverse China’s very large and potentially destabilizing capital account deficit. Its strategy may be working. On Wednesday the IMF described the new pricing mechanism as “a welcome step as it should allow market forces to have a greater role in determining the exchange rate”. It followed by noting, a little obviously, that the “exact impact will depend on how the new mechanism is implemented in practice”.
- Monetary freedom. The well-known “impossible trinity” makes it impossible for a central bank to control both domestic interest rates and the exchange rate if its capital account is open. Although technically not open, China’s capital account is porous enough for all practical purposes. This means that as long as the PBoC intervenes in the currency, it cannot provide debt relief to struggling borrowers, and to the economy overall, by lowering interest rates without setting off potentially destabilizing capital outflows. This constraint would be even tighter if the Fed began to raise interest rates. Reform of the exchange rate mechanism restores interest rate flexibility.
There is no way to say for sure which of these drove the PBoC decision because the PBoC, like most central banks, has preferred to be a little vague about its reasoning, but I suspect that it changed the currency regime primarily either to gain monetary freedom or, more likely, to qualify for inclusion in the SDR. I doubt that the desire to turbocharge exports played much of a role, but I worry that if the PBoC was hoping to reverse the huge deficit on its capital account, the success of its plan will hinge on whether it was able to distinguish between fundamental demand and technical demand.
What determines the PBoC’s best estimate of the appropriate exchange rate?
The exchange rate has several functions in any economy, and what the PBoC decides is the most appropriate exchange rate depends on what it is trying to accomplish. These include:
- By transferring wealth from one sector to another, the exchange rate can be used to subsidize favored sectors at the expense of others. High exchange rates benefit household consumers, the services sector, and urban residents, among others. Low exchange rates benefit the tradable goods sector and commodity producers, among others.
- This process of transferring wealth also means that a higher exchange will speed up the rebalancing process, in this case by transferring wealth from the PBoC and the tradable goods sector to households.
- The interest rate and the exchange rate are two of the most important prices in an economy, or put differently, they are two of the most important pieces of information economic entities, including businesses, use to make investment and operating decisions. When the RMB trades at its fundamental value, economic agents within China are most likely to make the decisions that optimize overall value today and preserve the sustainability of economic behavior. Anything that pushes it away from fundamental valuations will distort the investment and operational behavior of all economic entities.
How does the market provide information?
We can usefully think of the “market” as a machine that processes a vast amount of information quickly and smoothly. Any agent who possesses superior information about a product or service that will cause a change in its supply or its demand will buy or sell based on the information. His buying or selling becomes the way in which the information is absorbed by the market and presented, in the form of a price, to all other agents.
This isn’t necessarily the most accurate of ways in which to determine a price but it seems to be more accurate than any other method we have been able to come up with. Put differently, it seems to be the most accurate way to drive the allocation of goods and services in a way that maximizes social wealth (which is, after all, what a market is supposed to do). We shouldn’t assume, however, that with the market all of the tough questions have been adequately answered.
The market implicitly does determine the answer to these questions, like the trade-off between the present and the future, or the different values it places on the needs of different social groups. We know that the market does these things because that is what it means for the market to clear, but the answers it provides will vary according to the institutions, including moral values, that form part of the system within which it operates.
One of the most important advantages, or efficiencies, of “letting the market decide”, however, is that it doesn’t seem like the answers the market gives us are in fact affected by our institutional setup. The market’s “decisions” are given a veneer of neutrality that everyone accepts, even though the decision is not neutral at all. This seeming neutrality reduces the political maneuvering that might otherwise occur.
Full article here Michael Pettis’ China Financial Markets