China's Currency: Too Weak or Vastly Undervalued?

The Chinese currency has been the target of criticism from President Barack Obama on down in Washington. The calls for it strengthen have intensified this week, during President Hu Jintao’s state visit to Washington.

Chinese Yuan and US Dollar
STR | AFP | Getty Images
Chinese Yuan and US Dollar

But viewed against other currencies, it’s far from clear that the yuan is all that artificially depressed, analysts say. Your stance largely depends on which hemisphere you find yourself in.

“Is it vastly weaker than it should be, or vastly undervalued? I think most in Beijing would disagree with that, and most in Washington would agree with that,” Daniel Hui, a foreign-exchange strategist for Asia at HSBC, said. “The data says that it’s somewhere in the middle, possibly closer to the Chinese view of the currency valuation.”

There’s hot debate on how exactly you should value the yuan, of course, and analysts say there’s too much attention paid to how it trades against the U.S. dollar. But China’s current-account surplus as a share of gross domestic product is now at 4 percent, Hui said, similar to its range in the early parts of last decade, and off a high of just below 11 percent in 2007.

Most analysts expect continued slow appreciation in the yuan. It rose around 3 percent in the second half of last year. That was after the surprise announcement by the Chinese government last June that it would adopt a more flexible exchange rate policy against the dollar, a depegging that resulted in a one-day gain of 0.42 percent against the greenback.

Analysts say Beijing appears to be managing the yuan against a bundle of currencies, though it’s unclear how it is comprised. Unlike Singapore’s rule-based bundle, which is fairly predictable, China’s strategy is still opaque to currency analysts.

Still, the direction is clear. Both HSBC and Credit Suisse expect the Chinese currency to gain another 5 percent this year, an annual rate that the central bank appears to be targeting. Besides comforting critics in the West, a stronger yuan cuts into inflation and raises purchasing power for Chinese consumers, a major focus for policymakers.

“A bit of currency appreciation does help with the inflation problem, and it does help by putting more money in households’ pockets,” Olivier Desbarres, the director responsible for Asian foreign-exchange strategy at Credit Suisse, said. “But it also has a potential cost. If you appreciate your currency aggressively then you will make some industries uncompetitive. Those industries may have to relocate, and that means lower employment. The Chinese will tell you it’s just not a risk they are willing or able to take.”

But the rate is likely to be steady and controlled. If the U.S. and global economies show faster-than-expected growth this year, the yuan may be allowed to gain even more ground. Gains in the currency help combat inflation, by making imports cheaper and improving buying power.

“The risk of inflation is towards the upside, ” Wei Yao, China economist with Societe Generale, said. “It is still the biggest challenge for Beijing at the moment.” Gains in food prices in particular threaten social stability. With inflation running at 5 percent in November, it could peak at 6-7 percent later this year, Yao added.

Invest China - A CNBC Special Report
Invest China - A CNBC Special Report

But although a stronger currency helps moderate inflation, Beijing isn’t using the yuan as a policy tool, foreign-exchange experts say. The Chinese government is much more likely to combat inflation through direct quantitative tools, such as reducing bank landing and tightening the money supply. The steady but slow appreciation of the currency is more of a backdrop for Beijing.

Although the appreciation may be heading in one direction in the long term, the move away from a dollar peg has made the yuan more difficult to gauge. Beijing’s exchange-rate policy is also likely to throw in a few surprises in its appreciation.

“Yuan appreciation won’t be linear — it can be very, very choppy,” Desbarres said. “It is probably in the Chinese central bank’s interest to keep everybody guessing a bit.” Some uncertainty in the short-term direction prevents Beijing from having all the heavy lifting, if all currency trades are lodged against it.

The long-term gains in the yuan make only an incremental difference to the Chinese macro economy, experts say, and will have even less influence abroad. The rate of gain has so far done enough to prevent an all-out trade war, and has also ensured the U.S. Treasury has resisted calls to dub China an official currency manipulator.

“It really relies on the Chinese policymakers doing just enough to keep the Americans just happy enough,” Desbarres said.

"The renminibi probably could and should be stronger. But it’s not the slam-dunk transgression that many in the West think it is." -FX strategist for Asia, HSBC, Daniel Hui

Within China, there’s debate as to how much a rising yuan would help the U.S. economy. Yao Yang, the director of the China Center for Economic Research at Peking University, said in a forecast for 2011 that 44 percent of China’s trade surplus comes from U.S. companies operating in China. By his calculations, Apple’s iPhone accounted for $1.9 billion of China’s $143 billion trade surplus with the United States in 2009.

His center estimates that an appreciation of the yuan of 5 percent would cause U.S. employment to rise by just 0.02 percent. Even a 20 percent increase in the Chinese currency would only cause U.S. employment to inch ahead 0.16 percent.

Although the U.S. jobless rate has finally dropped below 10 percent, and currently sits at 9.4 percent for December, the American economy still faces a long, hard slog. U.S. Federal Reserve Chairman Ben Bernanke has warned it may take as much as five years before the unemployment rate falls to a more typical rate of around 6 percent.

In the meantime, Washington is likely to continue pointing fingers toward the yuan as the cause of lost jobs — even if that’s not born out by analysis, analysts say.

“It is convenient for the U.S. politicians to point to an external factor,” Hui said. “The renminibi probably could and should be stronger. But it’s not the slam-dunk transgression that many in the West think it is.”