Yuan: the implications of a revaluation

The Chinese Yuan is one of the most interesting and ‘hot’ economic topics in the last few years. The controversy surrounding the Yuan stems from whether it is being undervalued or not. Here are a few points.

The Yuan exchange rate is a nominal price. As with all nominal prices, it should not affect real outcomes in the long-run. Suppose, according to the US, it is undervalued. Then, if the real exchange rate is to be constant, an undervalued Yuan should be completely offset by a higher Chinese price-level/higher domestic inflation. To prevent this inflation the Central Bank has to sterilise the net flows of money by selling bonds, and this effectively contracts the money supply. This fixed Yuan ER is the distinct form of monetary policy that China has been carrying out for the last few decades.

The Yuan being undervalued is being seen as the steady accumulation of foreign reserves as China is running systematic BOP surpluses. A revaluation is seen as bringing the economy closer to BOP equilibrium.

A large revaluation is more compatible with the move to float the Yuan. If this were to happen, it would have to coincide with a removal of capital controls. China is known to impose stringent restrictions on the outsourcing of domestic savings abroad. If the removal of this restriction were to happen, it is possible that the capital outflows could overwhelm the prior net inflows of money, such that the new equilibrium exchange rate is lower than previously.

Another problem is that, in expectation of a Yuan revaluation, there are ‘hot’ speculative inflows into China with the idea of selling Yuan once it has appreciated. These hot ‘inflows’ could be contributing to China’s BOP surpluses, and the removal of these speculative inflows once the Yuan is re-valued could also adjust the exchange rate downward.

To further complicate the issues behind a ‘revaluation’ or general floating, are: If the BOP surplus is to be eliminated, will it mean China has a Current Account Deficit and Capital Account Surplus, or vice versa? Given the possibility that China may be net exporters of savings, it is possible for the Current account surplus to increase and for there to be a corresponding capital account deficit. If this were to happen, it negates wild ideas that the bilateral trade deficit US has with China would reduce. On the other hand, there is a possibility of an import surge as the price of oil/metals/minerals drops, and this could possibly move China into a Current Account deficit.

The conclusion behind the above analysis is that one can never be too sure how the Yuan will move in relation to an initial revaluation. What complicates things is that as China continues to revalue the Yuan, it will most likely be in conjunction with a move to free its capital account and to float its exchange rate. This means that the common saying that ‘the Yuan is systematically undervalued’ may not hold true as China opens its economy.