UPDATE 4/11: I posted more links on RMB appreciation on 4/11 when the RMB crossed the 7:1 mark.
caveat: another long post on RMB appreciation that will be boring for those not interested in this topic.
I posted on ways to Hedging USD-RMB risk via Exchange Traded Notes on Mar 20 and followed up with other post on RMB appreciation on Mar 30. This topic is especially important for me as our Beijing operations are all in RMB-denominated expenses and because of other potential China related investments that I’m considering.
Here are some more links on this topic, organized in this logical argument:
- Fighting inflation is stated focus of Chinese central bank
- However, increasing interest rates will also drive RMB appreciation
- Increasing RMB appreciation will increase hot money inflows
- However, business failure and unemployment will result, which will mitigate policymaker’s interest in adjusting too fast
- The USD will of course continue to be the primary reserve currency for the foreseeable future. Nevertheless, a new reserve currency is being born in China, and individuals and companies who do business with China should treat it as such.
Fighting inflation is stated focus of Chinese central bank
On April 1, China Daily reports that the central bank monetary policy committee signaled a focus on fighting inflation. One implication of this is an increase in interest rates:
According to some experts, the notion of “stablelize expectations” implied that the central bank might raise interest rates in the near future. “Compared with issuing bank notes, or raising reserve requirement ratio, an interest rate hike is more effective in stabilizing inflation expectations,” said Guo Tianyong, director of China banking industry research centre at Central University of Finance and Economics.
Increasing interest rates would reduce the growth in domestic money supply, which should reduce demand for real goods and reduce the prices for those goods.
However, increasing interest rates will also drive RMB appreciation
Increasing interest rates not only reduces domestic money supply, but also increases the value of the RMB relative to foreign currencies. The article goes on to say:
The central bank also said that it would continue to improve the managed floating exchange rate system, and enhance the flexibility of the RMB exchange rate.
This veiled, Greenspanian policy statement seems to telegraph further appreciation, since “flexibility” can’t possibly mean depreciation from the current level given the large and increasing imbalance of foreign reserves.
Increasing RMB appreciation will increase hot money inflows
According to the blog China Stakes, China experienced the largest foreign exchange monthly increases in Januaryever:
By the end of February China’s foreign exchange reserve had reached $1.6471 trillion, while in January this number stood at 1.5898 trillion. So in January and February China’s foreign exchange reserve grew by $61.6 billion and $57.3 billion, respectively, the two largest monthly increases ever.
During the first two months in 2008, while China’s trade surplus actually slowed, foreign exchange reserves reached 2.5 times trade surplus and FDI inflow. Usually this can be interpreted as drastic hot money inflow.
A government official, speaking privately, said, “The interest rate cuts by the US Federal Reserve, which further widened the interest spread between China and the US, and RMB appreciation are new to the situation in 2008. Interest spreads and currency appreciation can bring considerable profits. I think this is an important reason for the accelerated hot money flooding.”
I confirmed the foreign exchange reserve numbers quoted by China Stakes at Forbes.com here which goes own to explain why hot money inflows drive foreign reserves up:
The reserves, the world’s largest, have ballooned because the People’s Bank of China, in order to hold down the yuan, buys most of the dollars that flow into China. The central bank then has to sterilise the impact on the money supply by mopping up the domestic currency it creates in the process. The jump in reserves will make this job harder.
However, increased business failure and unemployment may result from RMB appreciation
The countervailing factor that Chinese policy makers need to deal with is business failure and unemployment. Bill Dodson at This is China! BLOG concludes that “Times in China, They Are A Changin’” and shares a story about a friend who was doing sourcing for a European buyer with a large order:
My friend hadn’t known if they could meet those numbers, so he didn’t make any promises at the meeting. Instead, he made calls around to suppliers he knew were still in business. “More than 6,000 factories have closed just around Guangzhou,” he said. Of course, his declaration was anecdotal; but his message was clear: A LOT of factories have closed recently in the region.
China Stakes reports on China’s Textile Exports Hit Hard by the Yuan’s Appreciation. Increasing labor costs, increased RMB appreciation, and commodity price increases, have all driven production costs by 20-30%. With reduced demand caused by slowdown in the US economy, there seems like there is a perfect storm hitting Chinese textile exporters that will cause the least efficient suppliers to go out of business, throwing workers out of work in this adjustment period.
The emergence of a new reserve currency
In my earlier March 30 post about RMB appreciation I highlighted a post by Gary Smith at Seeking Alpha about a Morgan Stanley report about why the USD would continue to be a reserve currency. However, what I found interesting about the report was the comment by Stephen Jen of Morgan Stanley that “In the long run, the most likely contender to the USD as the dominant international reserve currency, in our opinion, is likely to be an Asian currency centred on the Chinese RMB.” He offers a conceptual model for understanding what a reserve currency is. For businesses with significant involvement in China, it seems that the RMB is starting to satisfy this conceptual model.
Because the Morgan Stanley website is so poorly designed, I am going to zhuanzai to post here in a big way in case the original post disappears off the Morgan Stanley website into the dark Web:
With the narrow and broad dollar indices at their record lows, investors may now wonder if the dollar will soon lose its reserve currency status. But we caution against confusing the international role of the dollar as the supreme store of value with its two other roles – as the dominant international unit of account and medium of exchange. These latter two functions of an international currency do not change abruptly and are supported by increasing returns to scale. It will take a long time to supplant the dollar as a reserve currency, though we concede that the dollar’s lead over other currencies is shrinking (see Should Asia Hold EUR Reserves, October 17, 2002).
…Essentially, there are three uses of money: (1) unit of account; (2) medium of exchange; and (3) store of value . This is what we learned in Econ 101. But in the context of international monies, we need to consider these three uses of money from the perspectives of both the official and the private sectors.
1. Unit of account. From the perspective of the official sector, a country uses an international money as a unit of international account when it pegs to such an international currency. On the other hand, from the perspective of the private sector, an international currency is used as a unit of account in cross-border trades in goods and services, as they are often priced, invoiced and settled in currencies other than those of the two trading countries (e.g., trade between Argentina and Thailand being priced in USD). (Trade between EM economies tends to be invoiced almost fully in USD or EUR. But trade between industrial and developing countries tends to be priced in the currency of the industrial country or the USD or the EUR.)
2. Medium of exchange. International monies are also held by both the official and private sectors for ‘settlement’ purposes. For the official sector, a key reason for holding a certain international currency is for intervention purposes. For countries that are pegged to a certain international currency, usually the intervention currency is the anchor currency and so, naturally, the central bank of the pegging country warehouses most of its reserves in this anchor currency. For the private sector, a certain international currency is preferred to others because exchange rates are quoted in bilateral terms and one particular bilateral exchange rate is almost always significantly more liquid than others. For example, it is cheaper to convert KRW into ZAR through the dollar. The dollar, thus, is the medium of exchange through its role as the ‘vehicle’ currency, and the private sector holds these ‘vehicle’ currencies because of their convenience of use.
3. Store of value. Preserving and enhancing the value of the reserves and private portfolios are important to the official and the private sector, which tend not to hoard international currencies that don’t hold their value over time or are volatile.
The Dollar Has Retained Some, Not All, the Qualities
Essentially, the dollar still retains its qualities in the first two uses of money – unit of account and medium of exchange – but appears to be a poor store of value. Here are some specific thoughts we have:
First, we don’t take seriously the threat that some oil exporters will soon price and invoice their exports in EUR or RUB, instead of USD. In our view, the dollar will remain the most efficient unit of account for many internationally traded commodities. Many of the key commodity exchanges are physically located in the US. It makes little sense for individual oil exporters to unilaterally change their pricing menu to any other currency. Also, pricing and invoicing oil should not materially alter what oil exporters do with the receipts, at least in the short run. Many oil exporters have most of their external debt denominated in USD, mainly because oil prices are in USD. There will, thus, be a great deal of ‘stickiness’ in currency denomination in commodities. (In general, a change in the invoicing currency for commodities will have little effect, except that the exchange rate risk to US importers will increase, while that for EMU importers will fall.) The dollar will reign as the dominant currency in trade in commodities, in our view. Also, ‘South-to-South’, i.e., EM to EM, trade will likely mostly be priced in USD. While the liquidity and reputation of many EM currencies have significantly improved in recent years, it may take many years before Korea will accept THB in its trade with Thailand. (According to Goldberg and Tille (2008), Macroeconomic Interdependence and the International Role of the Dollar, NBER 13820, 66-85% of AXJ’s exports and imports are invoiced in dollars. Roughly a third of EMU’s exports are invoiced in dollars.)
What is interesting about the first point is that for China export businesses and for services businesses to foreign companies, it seems that the unit of account that best serves the domestic China business is RMB, and that there will be increasing pressure for foreign partners to take on foreign currency risk.
Second, the dollar’s role as the medium of exchange is well preserved, in our view. More than half of the bilateral pegs in the world are still referencing the USD. While the number of pegged regimes is declining, this is due more to these countries’ need for independent monetary policies, than to the USD pegs being replaced by EUR or other pegs. Further, the dollar remains the main intervention currency even for most countries that are not pegged to the USD (e.g., Japan). As long as the dollar is still the intervention currency of choice, central banks will need to keep the bulk of their official reserves in USD.
At the same time, with the exception of the European currencies, almost all the bilateral exchange rates are priced against the dollar. As trade globalisation and financial globalisation accelerate, these USD-crosses – ‘paths of least resistance’ – should become even more efficient. The dollar, therefore, may have even enhanced its vehicle currency status, in our view. The analogy is the use of English language. One need not debate whether this is the best language in the world; the more people speak it, the more it will be used.
This second point also suggests that the lingua franca role of the dollar will continue.
However, the dollar has a major problem as a store of value. Reflecting the still-large US C/A deficit and the financial crisis in the US, the dollar has obviously become unattractive as a store of value. (Similarly, the poor economic performance of the US in the mid-1970s and late 1980s contributed to both the weakness in the dollar as well as its declining reserve currency status during those periods. However, in both cases, the dollar eventually recovered its reserve status.) The main argument for investors not to sell the dollar now is that it already appears extremely under-valued, measured by many valuation models, including our own. Having said this, however, it is important to note that these policy and macro problems can be fixed, and a flexible economy such as that of the US should be able to re-orient itself. At the same time, what is almost not reversible, in our view, is the structural improvement in the economic and institutional fundamentals of many EM countries. To some extent, the rest of the world has copied and improved upon the American model. It is now up to the US to restructure itself to compete in a more competitive world.
In summary, Stephen Jen suggests that the dollar will remain a reserve currency for some time, but will not have a monopoly position on this role. The Euro will increasingly play a role as reserve currency and countries like China and the Middle East oil producing countries are already holding reserves in a mix of Euros, Yen and Dollars.
On a personal basis, I continue to feel strongly that the Chinese RMB (even with transaction costs, convertibility issues, and politica uncertainty) is an important part of one’s personal reserve currency, which seems increasingly wise to be diversified against multiple world currencies. However, it does seem that the dollar is now undervalued relative to the Euro so I’m not jumping into selling dollars to buy Euro.
