If there was any question whether China’s currency was overvalued, it’s been settled now. For the third day in a row the renminbi traded ‘limit down’, hitting the lower band of the trading zone prescribed to it by the mandarins at the People’s Bank of China (PBOC). Traders who were caught out by the decision to devalue the currency earlier in the week are playing catch up.
It’s a dangerous thing trifling with values, isn’t it? The PBOC actually had to intervene on Wednesday to support the currency. Make up your mind China. Stronger or weaker, which is it?
Deputy Governor Yi Gang took the unusual step of holding a press conference to show everyone the authorities were in charge. He said the PBOC will act, ‘when the market’s volatility is excessive’, according to the Wall Street Journal. “Trust the market, respect, fear the market, and follow the market”, he added. Come again?
Nobody respects the market anymore. It’s one of the central truths of our time. People in positions of power – central bankers and politicians mostly – think they are smarter than the market, that they know better what prices should be. That they can control markets through interest rates and trading bands and press releases. It will be entertaining to watch China try and tell the market what the real value of its currency should be.
China’s currency is still overvalued and you’ll see “persistent weakness from hereon in”, according to Soc Gen global strategist Albert Edwards. That contradicts the claims by PBOC officials, made on Tuesday, that the devaluation was a “one off” event. Perhaps they meant the process of devaluation by some 15-20% was a ‘one off’. But the main point is, expect to see more weakness ahead, and more volatility in the stock market as a result.
Edwards was one of the early bears on the currency. What did he see that the bullish speculators that piled into Chinese bond funds did not? Edwards looked at the real effective exchange rate. The nominal exchange rate is what is mandated by the PBOC, or with other currencies, the rate the market sets. The real effective exchange rate tells you whether a currency is overvalued or undervalued in terms of what it actually buys in each country.
The classic example is the Big Mac burger. Let’s say the pound/dollar exchange rate is 1.56, or that one pound will buy you 156 US cents ($1.56). That’s the nominal exchange rate. If a Big Mac costs $1.56 in the US and £1 in the UK, the real exchange rate is the same as the nominal exchange rate. If a Big Mac costs £1.20 in the UK, the pound is over-valued. If a Big Mac costs 80p, the pound is undervalued.
In point of fact, it’s been ages since I ate a Big Mac. But data from McDonald’s shows that the average price of a Big Mac in the US was $4.79 in July. In the UK, it’s £2.69, or $4.20 at the currency exchange rate. That’s good value people. Get on it.
But back to China. Edwards says China’s real effective exchange rate against the US dollar was up over 50% since early 2006. In plainer terms, China’s currency became a lot less competitive in terms of boosting exports and growth. Conversely, the stronger real effective exchange rate probably had a lot to do with strong global capital flows into the country, some of which were undoubtedly bets on currency appreciation.
So now we know who was caught out by Tuesday’s move. The renminbi bulls. That’s who. The more important question today is whether this manageable adjustment in the value of China’s currency or ‘something else’. If it’s a matter of tweaking the right dials and knobs, then this week’s anxiety in global markets will be mercifully quick.
But what if the Chinese are just making it up as they go along like Janet Yellen, Mark Carney, and Haruhiko Kuroda, and Mario Draghi? What if all these central planners are operating under the delusion that they’re in control of values? And what if the world we live in is just a giant financial simulation of what life would be like if all macroeconomic and microeconomic behaviour was controlled by academics and bankers?
The last idea is the scariest (or the best, depending on your current quality of life). It’s also the one most likely to be true. Oxford philosopher Nick Bostrom said as much last month when he concluded that you and I could be living in a “fake universe”. By “fake”, he meant a universe which was really an elaborate computer simulation.
It’s all very Matrix-like. But at the financial level, it’s undoubtedly true. We are living a simulation. This is a test of the kind of economy and world you get with interest rates at the zero-bound. Price signals are suppressed. Values are distorted. Long-term economic calculation becomes impossible. In short, it’s a horrible world.
But right now, it’s the only world we have. So let’s press on. And let’s finish with one last note about China. Did you see the big fireball on TV last night? An explosion equivalent to 21 tonnes of TNT rocked the industrial port city of Tianjin overnight. Early reports have 44 fatalities and 500 injured. The blast was blamed on ‘dangerous chemicals’.
One of the pictures from the blast zone caught my attention this morning. Dozens (if not hundreds) of new cars were destroyed. Tianjin is a major export hub for China’s manufacturing engine. It was not a good day to be a Volkswagen.
The destruction of so many shiny brand new cars hardly puts in a dent in the economic problem: massive productive over-capacity across the globe. This is the harvest of globalisation. Lots of goods and services are cheaper than ever. For consumers in the West facing no real growth in nominal wages, it’s what keeps the world affordable. Thanks to China, everything seems to be getting cheaper (except houses, healthcare, and alcohol).
And there we come to the big topic on the tip of everyone’s tongue: deflation. Will China’s move spark another round of global currency devaluation and deflation? And if so, what you should do you about it as an investor.
Category: Economics