Andy Xie: Getting The Yuan Right

Everyone is now talking about Yuan's appreciation. Now back in April, Andy Xie wrote the following piece, Get the Yuan Right, Prove Pundits Wrong and Andy actually thinks the opposite. He reckons that the Yuan appreciation is a bubble!!

• Hype over an 'imminent' increase in yuan value ignores China's greater need for higher interest rates and fewer bubbles
  
  Unless China exits its economic stimulus quickly, the nation's inflation rate could rise to double digit levels sooner than many expect. The right sequence of events for a proper response to inflation would be to raise interest rates and then, if necessary, move the yuan exchange rate.
  
  But acting on the currency first, especially in small steps, would further inflate China's property bubble and inflation, potentially leading to a major economic crisis in two years. A small increase in the yuan's value would fail to resolve two pressing problems: inflationary pressure at home, and political pressure from the United States. Moreover, a small appreciation would attract hot money, stoking inflationary pressure.
  
  Imported goods' share of consumption is too small in China for a small currency appreciation to affect the consumer price index. At the same time, a minor appreciation would fail to placate U.S. interest groups, some of whom are demanding a rise in yuan value of one-third or more. Some argue it should double in value. Indeed, a slight appreciation would merely exacerbate existing problems by emboldening U.S. supporters of a stronger yuan to demand even greater appreciation.
  
  Meanwhile, financial markets are back on the yuan appreciation watch. Inflation pressure at home and political pressure from the United States have inflamed expectations. Every week or two, the media reports that some notable person has predicted an imminent yuan appreciation of 5 percent or so. So much ink has been spilled on this issue that the consensus on yuan appreciation has become the longest lasting and most widely accepted consensus in financial history. It's lasted for so long because financial markets have few stories to stir fry, and an appreciation of a pegged currency is a free lunch. Nothing gets financial markets more excited than a free lunch.
  
  The intensity and persistence of yuan appreciation expectations point to support for China's vast property bubble. These expectations have increased the concentration of hot money in China, which in turn has caused excess liquidity and speculation, fueling the property bubble.
  
  By all measures (stock value to GDP ratios, inventory value to GDP ratios, new property sales to GDP ratios, price to income ratios, rental yields, and vacancy rates) China's property market is one of the biggest bubbles ever. It's probably much bigger than the U.S. property bubble relative to GDP.
  
  Now, the same liquidity that fueled the property bubble is leading to rapid pickup for consumer price inflation. One just needs to look around to see the seriousness of the inflation picture, regardless of how it's measured. Denying that inflation is serious in China right now is akin to burying one's head in the sand. This sort of denial is how countries in Southeast Asia got into a crisis situation in the past: They kept real interest rates too low and fueled speculation that eventually destroyed their banking systems.
  
  If China's economic stimulus is withdrawn, the property bubble will cool. And it may even burst. This is why so many interest groups consistently argue against higher interest rates. Instead, they support using currency appreciation to cool inflation.
  
  Why is this policy option so popular among interest groups? Because it would fuel the hot money inflow, which in turn would support and expand the property bubble. Of course, inflating the property bubble will only worsen inflation. And the odds are that a small currency appreciation would only make the property bubble bigger and inflation worse.
  
  In a standard economy, currency appreciation cools inflation by decreasing import prices. China's imports are mainly raw materials, equipment and components. A small currency appreciation would have virtually no effect toward cooling inflation. So while a small appreciation might be justified politically, it should not be used to fight inflation.
  
  On the other hand, a major appreciation or revaluation could cool inflation by removing further currency appreciation expectations. It would trigger a hot money exit from China, creating a liquidity crunch that would almost certainly burst the property bubble. I doubt anyone would support such a policy move.
  
  For China to achieve a soft landing from the current property bubble – if this is at all possible – interest rates must steadily increase by 2 percentage points in 2010, another 3 points in 2011, and further in 2012. Such a trajectory for interest rates would not burst the bubble, but it would prevent real estate interest rates from further declining in an atmosphere of rising inflation. At some point, real estate interest rates will start inching up and slowly rein in speculation. Stopping real estate interest rates from declining further would prevent inflation expectations from accelerating, which in turn could halt inflation's accelerating pace.
  
  Getting It Wrong
  
  But let's return to fact that the most widely held belief today on Wall Street is that a rise in the yuan's value is a foregone conclusion. In the past, Wall Street forecasters have had trouble getting big calls right. Indeed, over the past two decades Wall Streeters have missed three of the biggest calls: the East Asian Miracle, the Internet Revolution, and Financial Innovation, i.e., derivatives. All three mega-trends had considerable substance. But U.S. financial markets misread implications of these trends.
  
  In 1995, the most widely accepted consensus on Wall Street was that Southeast Asian currencies such as the Malaysian ringit would surely appreciate. At the time the East Asian Miracle – referring to strong, prolonged economic growth for Southeast Asian economies and South Korea – was all the rage on Wall Street. It was rooted in the fact that these economies had been growing with strength for many years.
  
  But it was wrong to conclude that their currencies should appreciate. Many well-known hedge funds took big positions on these currencies in 1995, but two years later the Asian Financial Crisis brought them down. Currencies that had been under appreciation pressure two years earlier suddenly collapsed.
  
  Wall Street got the causality of currency strength and economic growth all wrong. The East Asian Miracle was based on cheap currencies that supported export growth. Inflation ended the model, as inflation makes a currency more expensive. An export economy can avoid inflation with a big appreciation of its currency as soon as inflation hints surface. But when inflation persists for a number of years, a currency has already appreciated sufficiently in real value, and the right policy response is to increase interest rates substantially to cool inflation. In 1995, currencies of the East Asian Miracle economies were already overvalued after many years of high inflation. The Wall Street consensus then created speculative demand for these currencies and, hence, appreciation pressure. In other words, the appreciation pressure was a bubble.
  
  In 2000, the Internet explosion seized Wall Street's imagination. It was a revolutionary technology that promised to raise economic productivity substantially – and it did. But investors who enthusiastically bought Internet stocks lost billions.
  
  Too many analysts hyped Internet companies on the premise that companies would reap all the revolution's benefits. Although these companies were indeed driving the revolution, competition passed most of the benefits to consumers in terms of lower prices. Profits were sketchy.
  
  More recently, financial innovation in the form of derivatives and synthetic financial products promised to decrease risks and, hence, lower funding costs for all. The belief in their effectiveness led to rising demand and, hence, leverage. Subsequently, rising leverage led to a credit bubble. For a few years, the credit bubble kept the economy strong, controlling bankruptcy rates. A visible, declining risk strengthened the belief that derivative products were indeed decreasing risk, which further inflated demand for them. Now we now it was a bubble.
  
  Right on the Yuan?
  
  If Wall Street got its biggest calls wrong over the past two decades, might it be wrong on the yuan, too? On the surface, it seems self-evident that the yuan is under appreciation pressure. Like any product, a currency's value depends on supply and demand. When the two are mismatched, foreign exchange reserves rise or fall. China's foreign exchange reserves have risen massively in the past five years, which means demand for the yuan has exceeded supply. This could be viewed as prima facie evidence that the currency is undervalued.
  
  Some argue that pressure for a rising yuan is not a bubble by noting that China's large trade surplus contributes to about half of the increase in foreign exchange reserves. Hot money may be responsible for only half the pressure. Hence, they say, it cannot be a bubble. But history is full of examples of currency appreciation pressure building a bubble.
  
  I am surprised that China is still running a trade surplus. The surplus is declining, but considering how depressed the world economy is and how hot China's is, a trade deficit would be more likely. The surplus, I think, can be attributed more to distortions in domestic pricing than the currency's cheapness.
  
  First, high property prices are a major deterrent to middle class consumption. In mature economies, rising property prices boost consumption through a positive wealth effect because most middle class households already own property. In China, the positive wealth effect is limited because the credit system is not there for the middle class to monetize capital gains. But first-time buyers, such as newlyweds, have to save more to purchase property. Indeed, since prices are so high, parents have to save to help them. Hence, China's property bubble suppresses consumption and, therefore, boosts the trade surplus.
  
  Second, prices for middle class goods and services are very high. Autos stand out: Prices in China for cars, even those built domestically, are the highest in the world. Auto demand has been rising rapidly with middle class expansion, but it would rise even faster without price distortions. Imports would be much higher, too, which would reduce the trade surplus. Actually, though, consumption in China is higher that should be expected, since China's middle class incomes are only 20 to 30 percent of OECD levels.
  
  Third, China's taxes on the middle class are too high. The top marginal income tax rate of 45 percent applies at quite low income levels by international standards. The 17 percent VAT is also among the highest in the world. Because China tends to invest its tax proceeds, high taxes suppress consumption.
  
  If China's property and consumption prices as well as tax rates decline to international levels, would China still have a trade surplus? Good question. If the answer is yes, the right policy would be to adjust prices rather than the exchange rate.
  
  Whenever a country successfully industrializes, its currency value should appreciate. This appreciation can come in the form of a higher exchange rate or inflation. What worries me is that inflation has already happened. China's real exchange rate may have appreciated greatly in the past three years. Even though China's reported inflation rate has been relatively low, prices that one encounters in daily life appear to have risen enormously. Foreigners who visit China are often surprised by prices, which are even higher than in many developed countries. Even China-made retail products are more expensive in China than in other countries.
  
  I am not sure that yuan appreciation pressure is entirely a bubble. But a big chunk is. Instead of looking at appreciation pressure per se, it would be better to get rid of the hot money and clean up domestic price distortions. These should be the first steps. If yuan demand still exceeds supply afterward, the exchange rate should move.
  
  Many analysts argue that raising interest rates would attract more hot money. This is wrong. Hot money comes to China for currency appreciation and asset bubble reasons, not to chase interest rates. When an interest rate is raised, expectations for property price appreciation wane and hot money is more likely to fall than rise.
  
  Increasing the yuan's value a bit would certainly trigger more frenzy. Any new property booms that follow may support the economy for a time. But the long term consequences would be severe. Indeed, a small appreciation could make a crisis inevitable.
  
  The temptation for a small move in the exchange rate is high. It seems to be a cost-free step. Many hope the United States would be placated by it. Even though exporters may be hurt a bit, the near-term domestic economy could benefit. It may seem a perfect short-term fix. But it's the wrong thing to do, because there is no real free lunch. What's free one day could cost a lot more in the future.