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:
- “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