Should China Allow its Currency to Appreciate?

Post April 2005 China allowed the Yuan to appreciate gradually against the US dollar, but since 2008 China has maintained a hard peg against the USD at 6.8 ensuring that Yuan followed the dollar as the latter depreciated against the yen and euro.

China has emerged as world ace exporter, surpassing Germany in Dec 2009, and has come under scanner to keep its currency undervalued to shore up its economic and trade competitiveness. Beijing's policy of keeping the Yuan weak has helped China become the first key economy to recover strongly from the world financial crisis but at the expense of its key trading partners still nursing the wounds of recession, some analysts contend. The USD has depreciated substantially relative to other currencies since May of 2009. Since the Yuan is tied again to the dollar, the Yuan has depreciated by the same amounts, including 16% against the euro, 34 % against the Australian dollar, 25% against the Korean won, and 10 % against the Japanese yen. This substantially depreciation of the Chinese currency has made many other countries angry at China's policy of locking it to the US dollar.

The US and other countries worry that the undervaluation of the Chinese currency increases the demand for Chinese exports, and reduces China's demand for imports from countries like the US. Since China has largest population, and demand for the US and other countries grows, but the goods are uncompetitive in the Chinese market. The US especially wants to help reduce the high levels of unemployment found in many of these nations. US companies that would like to export more to China are hurt by the maintenance of the Chinese currency at an artificially low value relative to the dollar. As a result, employment by these companies is lower than it would be, so that this may contribute a little to the high rate of US unemployment. But I believe the benefits to American consumers far outweigh any loses in jobs, particularly as the US economy continues its recovery, and unemployment rates come back to more normal levels. This is acting as double whammy for the developed nations which are trying hard to get out of recession: Their imports are increasing and exports are becoming uncompetitive.

The opposite effects hold for China. Their consumers and importers are hurt because the cost of foreign goods to them is kept artificially high. Their exporters gain, but as in the US, that gain is likely to be considerably smaller than the negative effects on the wellbeing of the average Chinese family.

This policy will make the Chinese exports competitive and help China to amass foreign reserves, now more than two trillion dollars, could result in protectionism and even spark a trade war.

According to Purchasing power parity, the Yuan, if allowed to freely float, should trade at 3.8 per 1 USD. So there is no doubt that China is intentionally holding the value of its currency below the rate that would equate supply and demand. By pegging the Yuan to USD, China has virtually adopted the Monetary Policy of US.

With huge pile of foreign exchange reserves, China is investing back in the US in treasuries. The US has little to complain if China wants to hold such high levels of low interest-bearing US government assets in exchange for selling goods cheaply to the US and other countries. China's willingness to save so much reduces the need for Americans and others to save more, but is not differences in savings rates also part of the international specialization that global markets encourage? To be sure, why China is willing to do this is difficult to understand since they are giving away goods made with hard work and capital for paper assets that carry little returns.

One common answer is that China hopes to increase its influence over economic and geo-political policies by holding so many foreign assets. Yet it seems just the opposite is true, that China's huge levels of foreign assets puts China more at the mercy of US and other policies than vice versa. China can threaten to sell large quantities of its US Treasury bills and other US assets, but what will they buy instead? Presumably, they would buy EU or Japanese government bills and bonds. That will put a little upward pressure on interest rates on US governments, but to a considerable extent, the main effect in our integrated world capital market is that sellers to China of euro and yen denominated assets would then hold the US Treasuries sold by China.

International Diversification: Does it still hold water?

The Capital Asset Pricing Model (CAPM) and the Modern Portfolio Theory (MPT), suggest that individual and institutional investors should hold a well-diversified portfolio to reduce risk. Empirically there has been a low correlation between developed capital markets and emerging markets and conventional wisdom says that if the correlation between two asset classes is low, you can combine the assets into a portfolio with lower risk than the individual asset class. It is also argued that since differences exist in levels of economic growth and timing of business cycles among various countries, international portfolio diversification can be used as a means of reducing risk.

Financial crisis like that of Great Depression (1929), Asian Market crash (1997), Dot-com bust (2001) and Credit crisis (2007-08) have shown that these are the times when the investor needs the effects of diversification the most and in these times emerging and developed markets tend to be highly correlated. The volatility in the markets affects cross market correlations and after the crash, the co-movements of markets increase significantly, implying that the benefits of international diversification decreased considerably.

Emerging markets had a great decade. Their story was strengthened by the resilience of countries like Brazil, India and China and other Asian economies to the financial crisis which was seen as largely a developed world issue. Looking forward the story remains intact. For many people the future of investing can be summed up in two words: emerging markets. There has been a fundamental revaluation of the relative risks of the larger emerging markets and questions are raised whether the term emerging market is any longer appropriate. Moreover, stock markets across the world are becoming more integrated and it has been found from the studies that correlations have remarkably increased over the time and the incentive to invest in these markets is diminishing.

Another interesting result observed is that correlation coefficients are uni-directional, correlations going from the U.S. to Japan are not the same as those going in the opposite direction. This is due to the fact that trading hours of the markets are different and that the market that opens later typically contains information on what happened in the market or markets that had already closed. This result may indicate that the Nikkei 225 returns are much more correlated with the S&P 500 returns after the close of the U.S. market than would be the reverse case.

Although all the economies move through the various stages of the business cycle over the time, these cycles are not always synchronized across countries (e.g. one country may be in recession while a second country is in early upswing). The degree of synchronization of the economies is increasing over the time as the international capital markets become more integrated. However, it is very unlikely that they will ever be completely synchronized. The key implication of the lack of complete business cycle synchronization for investment analysis is that international diversification of equity portfolios is valuable. This is because, to the extent that country business cycles are not synchronized, global return covariances will be lower and portfolio managers who diversify globally will realize better returns-to-risk tradeoffs and higher risk adjusted portfolio returns.

References:

http://gbr.pepperdine.edu/072/diversification.html

http://www.apexinvestmentguru.com/investmenttalk.php?id=5