Tag Archives: Exchange rate

No free money anymore for buying Yuan

A sharp and sudden slide in China’s yuan is forcing investors to rethink one of the most reliable trades in financial markets over the past four years: betting on gains in the Chinese currency.

Over the past 8 years, yuan has strengthened by about 33%, making  investing in yuan related derivatives an almost free money to invest in for both institutional and individual investors. Chinese exporters have been big buyers of derivatives because they allowed them to hedge against the rising yuan. In many cases, the businesses are losing money in their operations but make profits because of the hedges, which generate a monthly income.

However, last week, guiding by the PBOC, renminbi dropped to its weakest level in seven months.The easy money gets tougher. 

The earliest reaction was this recent decline in the yuan reflects economic fundamentals, based on the fact that GDP slowed to 7.7% in the fourth quarter from 7.8% in the third quarter.But the fact that the exchange rate in China is not determined by the market rules out this possibility. For people who may not know about China’s foreign exchange regime: the exchange rate was determines by China’s central bank based on a basket of currency (including USD). Specifically , a reference point for the yuan is set daily and then lets it trade 1% higher or lower.  So the change in yuan is basically still driven by policy makers rather than market forces, although few people willing to admit that. 

From my point of view, there is at least tow reason why PBOC alter the trend of RMB movement.

The first being to shake out speculators as China prepares to allow a wider trading range for yuan, an essential step toward Chinese foreign exchange reform.Recent years, there has been a huge inflow of speculative money (or hot money ) to take advantage of both rising Yuan and higher interest rates. This could be problematic for China, whose central bank takes control over the exchange rates. To stabilize the exchange rate, PBOC and its state-owned affiliates has to absorb dollars, making China’s foreign reserve explode over the past few years. Meanwhile, inflation arise as banks exchange dollar into RMB and dumped them into the market. This has caused huge inflation and asset price bubbles in China.To curb the inflation and implement the long overdue exchange rate marketization, China is now trying to depreciate yuan and shake off speculative money from the system to  improve financial stability. China would need a more stable environment to unfold the exchange rate reform.

The second reason being to prepare for a foreseeable economy downturn brewing so long in China. It is known that China’s shadow-banking imposed a huge threat on the financial system of China. As QE retreating, hot money used to boost the irrational exuberance in asset market will retreat as well. The burst of bubble would obviously result in a huge economy downturn in China. Therefore, the only quick solution to prevent economy from recession would be to increase export.

Who Touched My RMB?

It’s always interesting to see how economic predictions and financial manipulations fail in China. The ridiculously high population/resource ratio turns China into a hungry giant that can easily overturn any rules: the Wall Street tycoons lost to Chinese housewives during the “gold battle”; Chinese government tried to stop the housing market’s craziness but ended up being one of the biggest obstacle to the success of taming the market. The list goes on and on.

And now it’s the RMB issue again. Bear with me if this topic is becoming increasingly boring for you. As the RMB’s behavior is totally going against the theory, it’s tempting to looking into the reasons behind all the weirdness.

Ever since the year of 2005, RMB has been appreciating internationally while depreciating domestically.

rmb_exchange_ratePicture source: XE

rmb_inflation_ratePicture source: Trading Economics

As explained clearly in this about.com thread, the value of a currency should be synchronized domestically and internationally. On one hand, when the exchange rate of RMB goes up, in theory, the demand of RMB will increase, leading to a decrease in the amount of liquidity, therefore the inflation will be alleviated, and eventually the value of RMB will go up. On the other hand, a higher value of RMB attracts investment from oversea, which will lead to a higher demand of RMB in the foreign exchange market and therefore drive up its exchange rate. However, historical data suggested differently: internationally up, domestically down. Why?

It’s a known fact that RMB was long undervalued in the foreign exchange market because of Beijing’s control. As Beijing gradually loose the leash, the exchange rate is bound to increase. So the problem must come from within the country. About the inflation, the government claims that “there exists measurement error that skews the statistical data”, and “the CPI data doesn’t fully reflect the reality”. Of course these official speech is too ambiguous to be believed, let alone the “CPI misreporting” can be interpreted both ways. As I see it, the mismatch of RMB’s value is a result of human intervention, or rather, government intervention.

This is not the usual fiscal and monetary policy I’m talking about. The level of governmental intervention in China is much higher than that. A rather prominent example is China’s “land finance”. Since all lands are owned by the central government by constitution, Chinese government has control over the price of every piece of land. To stimulate the local economy, local governments make huge spending every day, which almost always yields to budget deficits. To compensate the deficit, one of the most effective ways is to sell the lands the government owns. This is when things get crazy: since the government has control to the lands’ price, it can sell a certain piece of land at an extremely high price. And thanks to the heated housing market, there’s always a buyer. The buyer acquires the land at a huge cost, and naturally he’ll transfer the cost to customers. Therefore, the housing price is driven through ceiling. With the housing market heats up, there comes hot money. With the price of houses almost doubles every year, house owners’ pockets get inflated. The liquidity drastically increase in the market, and hence the inflation.

This kind of government intervention to the economy is not something foreseeable in the textbook, and the “land finance” is merely one piece of the puzzle. In a not-so-liberal economy, the government’s overexertion of its power to gain short-run benefit is clearly bringing problems to the economy in the long term. The mismatch of RMB value is one such example. What’s next? How to prevent these problems from happening in the future? Beijing needs to give better answers to these questions.

Don’t Let a Rising Yen Scare You Away from Investing In Japan

In recent blog posts I’ve spent a significant amount of time thinking about and discussing the effect the recent selloff of emerging markets will have on the global economy. Continuing with this theme, today I want to take a closer look at the effect the selloff has had on Japan (WSJ article), the third largest world economy (here’s a full ranking for those who are interested).

As I explained toward the end of a previous post, investor doubt in emerging markets has sparked a huge capital flow into safe haven economies like the U.S. and Japan because they are traditionally considered a safe investment. At first glance, this seems like good news for the economies of the U.S. and Japan. A strong currency at home usually implies the economy is growing; consumers are optimistic and purchasing power abroad increases. Unfortunately, however, this view hasn’t been reflected in Japanese share prices. The 225-share Nikkei Stock Average is down 13% since the beginning of 2014, compared to only a 5.2% drop in the S&P 500.

A closer look at Japan will give us a good idea about why some investors are not confident about Japan’s future. As the article states:

A year ago, optimism centered on the Bank of Japan‘s aggressive easing measures, which pushed down the yen’s value, which benefited large Japanese exporters by boosting the value of overseas earnings when converted into yen.”

It makes sense. Investors who had invested in Japanese companies previously were attracted to them because of the comparative advantage these companies had over companies located in countries with more valuable currencies. Now that this advantage is fading away, investors are worrying corporate profits will dwindle.

I would argue, however, that this view is a bit skewed. Although a strong yen hurts exports, Japan’s economy as a whole is showing signs of growth. These signs may even be strong enough for Japan to get out of its period of long-endured deflation:

  1. Housing starts in 2013 rose to the highest level in five years”
  2. “Japanese industrial output was recently at its highest in more than a year”
  3. “The unemployment rate fell to a six-year low of 3.7%.

Furthermore, as I’ve discussed before, I don’t think that the current capital inflow into Japan will last. After investors realize that their doubts in emerging markets were exaggerated by groupthink, capital will flow back out of Japan and Japanese exports will become more attractive once again.

(Revised): South Korean Exchange Rate

My brother and I both study in United States, therefore it costs more than $100,000 per year to pay for college in my family. As a result, I am very conscious about Korean won-US dollar exchange rate. Korean Won-US dollar exchange rate was as low as 900 Won per dollar in early 2008, but it rose rapidly to 1400 won per dollar by end of year 2009 due to financial crisis in 2008. When I started studying at the University of Michigan in 2008, my father sent me approximately 45million won, corresponding to $50,000 for tuition and living expenses. However, by the end of 2009, he had had to send over 77million won (corresponding to $55,000 – as tuition and living expense increased as well during 18 months), almost twice (in fact, 171%) compared to the amount he sent me a year ago. Thinking that 77 million won is “too much”, I decided to go back to Korea in order to fulfill my mandatory military service obligation for two years and wait until exchange rate settles down.

As the world economy recovered, so did Korea won-US Dollar exchange rate settled down. By the end of 2013, Korean won fell below to 1,050 won per dollar, recording lowest in more than two years. According to an article from Korea Herald (Korea keeps watch on won volatility), the main reason for the strengthening of Korean Won is due to economy recovery and United States’ quantitative easing. As more amount of US dollar is circulating in the market, relative strength of Korean won compared to US dollars grow naturally. For students like me, who needs to convert large amount of Korean won to US dollars, stronger currency is a big plus. However, as Korea has an export-driven economy with large sales of electronics and automobiles worldwide, a strong currency can hinder the export and act negatively in terms of economic growth.

Korean government and the central bank are well aware of it, and hinted that they are ready to intervene to curb the currency’s strength, according to the Wall Street Article (South Korea’s Won Falls After Officials Hint of Intervention). As Korean won hit a two-year high against the dollar (one possible cause being US quantitative easing) and five-year high against the Japanese yen (similarly, Abenomics being a reason), the Korean stock market ended at a four-month low, with Samsung Electronics stock decreasing by 5.5%. Korean central bank intervened last October by bringing $2 billion to slow gains, and it hinted that they are monitoring market flows closely to protect the economy against exchange rate volatility.

Recently, won-dollar rate has rose to 1080 won per dollar. Part of the reason might be tapering of US quantitative easing. According to Wall Street Journal in January 22nd (IMF Calls Out South Korea on Its Currency Policy), IMF told Korea that it should only intervene in exchange-rate markets to prevent volatility that might damage the economy. The Wall Street Journal highlighted the fact that “although countries can devalue their currency by buying foreign currency, the move puts upward pressure on other countries’ exchange rate and can fuel trade and political tensions between governments.”

For me personally, won-dollar rate of 1080 is too high and hope it goes back to 900 back in “good, old days.” However, I am aware that Korean economy is depending heavily on export on electronics and automobiles. From my memory, I remember Samsung electronics and Hyundai Motors still performed well in world market when currency rate was around 900 won per dollar. If they continue to make fine, quality products, I believe that they can still perform well globally regardless of exchange rate. Furthermore, companies should continue their best to cut down the cost and also manage their exchange rate risks by “hedging” it. So should Korean government try to manipulate the exchange rate? I think the market should decide what exchange rate should be.

Black markets break Argentina’s currency controls (Revised)

Imagine prices increasing 44% in 6 hours.  This weekend’s Wall Street Journal reports just that is happening in Argentina.  Friday ended a week of chaos for the Argentinean Peso that saw it devalued to the point that it started to fail as a medium of exchange.  After new currency control policies where created and others relaxed, the only thing that is certain is that Argentina is in real economic trouble.  In order to avoid repeating past mistakes, Argentina needs to take drastic action.

Argentinians do not seem to have great faith in their currency. Most of the people have been through this before.  Major transactions are done in US dollars.  This aversion the peso puts a constant downward pressure on the currency’s value relative to the US dollar.  When current President Cristina Fernandez de Kirchner was elected in 2007, she pledged to keep the value of their currency stable, but as this graph shows, the government has not been able to keep the currency from depreciating. This failure has an adverse effect on an economy that has increasing become dependent on imports.  The more their currency moves, the more dollars people will want to hold to protect against inflation and uncertainty.  It can be seen in the previous graph that the government’s 2011 restriction on the purchase of dollars only made the problem worse.  It also fueled a black market for US dollars that could work against any controls they try to implement.

Unfortunately, the results of this policy are coming to fruition.  Reported in the economist on January 22nd, in a bid to keep money in the country, the government put a limit on the number of transaction that could be done online, as well as increased taxes on items that where typically bought in dollars like cars.  This touched off a massive collapse in the value of the peso, shedding 15% of its value over the next two days.  It only ended when the government intervened through policy change two days later.  On Friday, the government made an unexpected decision and relaxed the restrictions on exchanging pesos for dollars, effectively deflating their own currency. The government was possibly hoping that by allowing more dollars out into the economy would have a stabilizing effect (It didn’t, as reported on Monday).  The policy of deflating the peso with out regard for inflation may have only increased demand for dollars. With the established black market, wealth will continue to leak out of the country, and the government will receive less and less revenue. This could see Argentina default on its debt again.

Argentina’s erratic and heavy-handed currency controls may have doomed it to repeat history.  But they don’t have to.  There may be way for Argentina to take out the black markets, get its citizens holding its own currency, and capture the world’s attention all in one action.  Argentina should be the first country to implement a digital currency. By doing this, it could address two of the main causes of the crisis, the black market for dollars and the lack of foreign investment.

The black market for US dollars would go out of business if the digital peso were implemented.  It would be all too easy to make such a transaction impossible to make.  In China, so called crypto currencies were used to avoid capital controls, but by making the currency the official currency and allowing/mandating that transactions are done in the new currency, they will make capital controls almost unavoidable, cutting out the black market.  This could lessen the flight from the peso, easing the devaluation.  It could even make any policy the government implemented more effective, as there wouldn’t be a black market to work against.  Such stability could see the return of badly needed foreign investment, which when paired with the extinction of the black market would signal recovery.  A digital currency could reverse the flow of wealth into the county, and it might even make Argentineans excited to hold their own currency again.  It certainly would captivate the world, as it would be the first country to attempt a digital currency, and that alone could drive investment, if not in the currency itself.

The monetary system in Argentina has been a mess for years.  The economy seems to stumble from crisis to crisis.  It has come to the point where commerce has stopped altogether.  It that’s not a failed currency, I don’t know what is.  Everything they have tried up to now has failed.  In order to take control of its money and its future, Argentina should implement a digital currency. It may be the most unlikely of countries to pioneer new monetary policy, but they certainly are in need of it most.

 

 

 

Argentina: An Emerging Market Squandering its Potential

As Latin America’s third largest economy behind only Brazil and Mexico with an abundance of natural resources and a diversified manufacturing sector, it is tough to understand why Argentina’s economy has been so unstable. Throughout the 21st century, Argentina has not been able to maintain a steady level of growth, frequently falling into severe recessions after short-lived spurts of rapid economic expansion.

A recent WSJ op-ed by Mary O’Grady, “Argentina’s Crumbling Economy,” paints a grim picture of the months ahead for the emerging market.  Some of the main causes the article presented for the degradation of the Argentine economy are (1) a high and underestimated inflation rate, (2) socio-political instability, and (3) the inevitable negative effect these factors have on the value of the Argentine peso.

(1) High and Underestimated Inflation Rate

The fundamental problem Argentina is currently facing is a high inflation rate combined with a government that refuses to admit it. The article states:

According to the Foundation for Latin American Economic Research (FIEL), based in Buenos Aires, inflation for December was 3%, driving the total for 2013 to 26.4%… The government claims annual inflation is 10.5%. But there is widespread distrust of official figures… Even the International Monetary Fund took note. In February 2013 it censured Argentina for its failure to divulge accurate inflation data to the public.

This spells trouble for the Argentine Economy on two fronts. First off and most obviously, an inflation rate of 25% will push up interest rates and decrease domestic investment, halting growth tremendously. Notice the recent spike in interest rates:

Argentine Interest Rate: Jan 2011 - Jan 2014

Argentine Interest Rate: Jan 2011 – Jan 2014

Secondly, the inflation shading the Argentine government is apparently performing hurts investor confidence. Not many investors would be willing to take the risk of investing in an economy whose government does not give accurate information about the inflation rate. It is likely that foreign direct investment will decline and capital will flow out of Argentina as a result.

(2) Socio-Political Instability

Another factor is social unrest. In December, police officers in Cordoba went on strike to protest low salaries, inviting thieves to loot more than 1,000 stores across the city. The governor of Cordoba was caught between a rock and a hard place after the national government refused to respond, forcing Gov. Jose Manuel de la Sota to increase the police officer’s salaries by 33%. This, in turn, sparked police protests in 20 other provinces across the nation. This type of thing can ruin an economy, not to mention a country. Political and social stability are prerequisites for economic growth. Forget high inflation rates. If daily transactions across the nation cannot be carried out due to the threat of looting and other crime, there is no telling how severe the recession could be.

(3) The Weakening Exchange Rate

The combination of high inflation and political instability has caused the value of the Argentine peso to plummet. As can be seen by the graph below, the peso has been steadily losing value, but has spiked recently jumping from 6.52 pesos/$ to 8.01 pesos/$:

Argentine Exchange Rate

USDARS spot exchange rate 2010-2014: shows how much the USD is worth in terms of the Argentine peso (ARS)

Argentines are selling their currency to whomever they can, causing a massive surplus in the market and bringing down its value.

It is sad to see a country with so much capacity for growth fall into what appears to be a serious potential recession. I do think, though, that even given the multitude of problems Argentina is currently facing, it is possible for it to avoid a fall from grace. It starts with an immediate and firm response by the national government to stop social unrest. After social and political stability are restored by whatever means necessary (whether it be increasing police officers’ salaries or temporarily replacing their positions with soldiers from the Argentine army), Argentina can begin to sort out its inflation problems. Perhaps a combination of short-term exchange rate policy and long-term supply-side policy could do the trick. What do you guys think are some potential strategies for Argentina to curb its high inflation?

Black markets break Argentina’s currency controls

Imagine prices increasing 26% in a matter of days.  This weekend’s Wall Street Journal reports just that is happening in Argentina.  The problem is so bad that stores are refusing to sell goods to customers, as they feel that the money will devalue so much they would rather hold the goods!  Friday ended a week of chaos for the Argentinean Peso that saw it devalue so much that it started to fail as a medium of exchange.  In a week that saw new currency control policies created, and others relaxed, the only thing that is certain is that Argentina is in real economic trouble.  Whether their policies will fix the situation is uncertain.  If Argentina doesn’t some how address the inflation that is occurring in their economy, as well as shut down the black market for US dollars, their currency control policies could have no effect.

Argentinians do not seem to have great faith in their currency. The people in Argentina have been through this before.  Most major transactions are done in US dollars.  This aversion the peso puts a constant downward pressure on the currency’s value relative to the US dollar, whose value is very stable by comparison. When current president Cristina Fernandez de Kirchner was elected in 2007, she pledged to keep the value of their currency stable, but it has become a source of inflation for their economy. As this graph from shows, the government has not been able to keep the currency from depreciating, which has an adverse effect on an economy increasing dependent on imports.  The more their currency moves, the more dollars people will want to hold to protect against inflation and uncertainty.  It can be seen in the previous graph that the government’s 2011 restriction on the purchase of dollars only made the problem worse.  It also fueled a black market for US dollars that could work against any controls they try to implement.

Unfortunately, the results of this policy are coming to fruition.  This past week, the floor fell out of the peso.  Reported in the economist on January 22nd, in a bid to keep money in the country, the government put a limit on the number of transaction that could be done online, as well as increased taxes on items that where typically bought in dollars like cars.  This touched off a massive collapse, losing 15% of its value over the next two days.  It only ended when the government intervened through policy change.

Friday, January 24th the government made an unexpected decision and relaxed the restrictions on exchanging pesos for dollars, effectively deflating their own currency. The government was possibly hoping that by allowing more dollars out into the economy would have a stabilizing effect.  While it stopped the free fall, this is not going to address the impending inflation, and could prove to be a Band-Aid on a bullet wound. With the established black market, wealth will continue to leak out of the country, and the government will receive decreased revenue. This could see Argentina default on its debt again.  The policy of deflating the peso with out regard for inflation may only increase demand for dollars.  The Economist details that next year’s fuel imports alone will cost the government about 15 billion.  With 30 billion in cash, Argentina simply can’t afford any money leaving the country at this point, yet the existence of these black markets for dollars almost ensures it will. Argentina’s erratic and heavy-handed currency controls may have doomed it to repeat history.

 

 

 

South Korean Exchange Rate

My brother and I both study in United States, therefore it costs more than $100,000 per year to pay for college in my family. As a result, I am very conscious about Korean won-US dollar exchange rate. Korean Won-US dollar exchange rate was as low as 900 Won per dollar in early 2008, but it rose rapidly to 1400 won per dollar by end of year 2009 due to financial crisis in 2008. When I started studying at the University of Michigan in 2008, my father sent me approximately 45million won, corresponding to $50,000 for tuition and living expenses. However, by the end of 2009, he had had to send over 77million won (corresponding to $55,000 – as tuition and living expense increased as well during 18 months), almost twice compared to the amount he sent me a year ago. Thinking that 77 million won is “too much”, I decided to go back to Korea in order to fulfill my mandatory military service obligation for two years and wait until exchange rate settles down.

As the world economy recovered, so did Korea won-US Dollar exchange rate settled down. By the end of 2013, Korean won fell below to 1,050 won per dollar, recording lowest in more than two years. According to an article from Korea Herald (Korea keeps watch on won volatility), the main reason for the strengthening of Korean Won is due to economy recovery and United States’ quantitative easing. For students like me, who needs to convert large amount of Korean won to US dollars, stronger currency is a big plus. However, as Korea has an export-driven economy with large sales of electronics and automobiles worldwide, a strong currency can hinder the export and act negatively in terms of economic growth.

Korean government and the central bank is well aware of it, and hinted that they are ready to intervene to curb the currency’s strength, according to the Wall Street Article (South Korea’s Won Falls After Officials Hint of Intervention). As Korean won hit a two-year high against the dollar (one possible cause being US quantitative easing) and five-year high against the Japanese yen (similarly, Abenomics being a reason), the Korean stock market ended at a four-month low, with Samsung Electronics stock decreasing by 5.5%. Central bank intervened last October by bringing $2 billion to slow gains, and it hinted that they are monitoring market flows closely to protect the economy against exchange rate volatility.

Recently, won-dollar rate has rose to 1080 won per dollar. Part of the reason might be tapering of US quantitative easing, but according to Wall Street Journal in January 22nd (IMF Calls Out South Korea on Its Currency Policy), IMF told Korea that it should only intervene in exchange-rate markets to prevent volatility that might damage the economy. The Wall Street Journal highlighted the fact that “although countries can devalue their currency by buying foreign currency, the move puts upward pressure on other countries’ exchange rate and can fuel trade and political tensions between governments.”

For me personally, won-dollar rate of 1080 is too high and hope it goes back to 900 back in “good, old days.” However, I am aware that Korean economy is depending heavily on export on electronics and automobiles. From my memory, I remember Samsung electronics and Hyundai Motors still performed well in world market when currency rate was around 900 won per dollar. If they continue to make fine, quality products, I believe that they can still perform well globally regardless of exchange rate. So what is the most “adequate” exchange rate? The one driven by the market, or the one government tries to set?

The US Dollar and Stock Market

According to Bloomberg, the US Dollar has grown for the eighth day straight, the longest streak since 2012 (http://www.bloomberg.com/news/2014-01-22/dollar-maintains-gains-on-fed-taper-bets-before-policy-meeting.html). What effect will the strong dollar then have on the US Stock Market?

Before I can speculate on the effect it may have, I want to drive into the reasons for the strong dollar. Two reasons cited for the upward trend of the dollar was a decrease in americans applying for unemployment and an increase in home sales. A decrease in application for unemployment shows an improving job market in the US. With more citizens in the work force, there will be more disposable income to spend and the US and it would be speculated that the US GDP would rise, which is constant with the US coming out of the recession of 2009. The upward increase in home sales is an indicator of the MPC. Home sales are big ticket purchases, and for the most part money is borrowed to finance these purchases. Money is usually borrowed more often in “good” times, either with a low interest rate or a surplus of income. Both of these are also constant with the economy recovering from the recession.

A third speculated reason for the growing strength in the US dollar is the speculation that the Federal Open Market Committee will continue its tapering of the dollar.  This isn’t a direct reason to invest in the US economy, because it indicates higher interest rates, which would lead to lower big ticket purchases. However, the Federal Open Market Committee continue to taper its bond purchases is a sign that the economy as a whole has recover and there is no more need for consumer spending stimulation.

So what will happen to the stock market? According to the CNBC experts “If the turbo-charged stock market rally is going to continue it likely will need help from an old ally – the weak dollar.” (http://www.cnbc.com/id/100543086). This makes sense when you look at economics from a theoretical standpoint. When the dollar is weak, exports are cheaper. Exports are then viewed more favorable by foreign companies, and money begins to flow into the US. When the dollar gets stronger, the exports look less favorable and the money flow into the US begins to slow down. If it were to grow strong enough, imports would be more favorable, and then it would be possible for the money to flow to other countries markets. This, however, seems like an unnecessary scenario. Although the US dollar is strong, I believe money will continue to be invested into US companies, strengthening the market. I believe the main reason for this will be the strength in the belief that the US economy has left the recession and is continuing to grow, this being signaled by the FMOC tapering its asset purchases.

Rising Yuan and Increasing Interest Rate: a double bind for China

If you are interested about China, one of the fastest growing countries in the world, you might want to look at some economic data and charts about this mysterious country.

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The above chart I copied from an article in the Wall Street Journal shows the trend of China’s exports and Chinese Yuan against dollar. (Yuan’s Rise Hurts China’s Exporters, by Richard Silk) We can see immediately the inverse relationship between foreign exchange rate of Yuan against dollar and China’s exports. However, knowing the inverse relationship dose not tell us any more then what we learned form an economic theory textbook. One has to zoom in to see a subtler and a more idiosyncratic picture that reflect the truth about this country.

In fact, if you look at the data that are closest to date, (i.e. the exports on November and December 2013), you might notice that November growth rate is unusually high. According to the Reuter’s article, (Hot money distorts China’s exports as speculators seek to cash in on Yuan, rate reforms by Pete Sweeney) the November exports in China rose 12.7 percent on-year, blowing past a Reuter’s poll that predicted 7.1 percent growth. However, the more recent article in Wall street Journal reported that exports in December were up just 4.3%. The question is, which figure reflect a more realistic trend of exports in China?

According to Pete Sweeney, the November data are distorted by what many economists called ‘hot-money inflows misreported as trade.’ Hot money are short term, speculative cash flows that seeks arbitrage opportunity when at least one of the two conditions exist:

1. The expected short-term interests increases;

2. The expected short-term foreign exchange rate increases.

Very unfortunately, China satisfied conditions—a rising interest rate and a strengthened currency. Therefore, it is more likely that the 4.3% growth rate is a better prediction for future trend. As Lu Ting and Sylvia Sheng of Bank of America Merrill Lynch wrote “We are concerned that rising RMB/USD and rising bond yields could once again entice capital inflows via over-reporting of exports,”

As a Chinese student, I always care about the economic growth in China, especially about exports, because it is the second most important driver of China’s GDP. China used to be a planned economy and is still transiting to a much more liberalized market economy. Since 2005, China has implemented foreign exchange reform and has adopted “a managed floating exchange rate based on market supply and demand with reference to a basket of currencies”. Specifically, Yuan is priced according to a basket of currencies, and is under the manipulation of People’s Bank of China (FED of China) when crisis occurs. Yuan has been strengthening ever since. Although whether Yuan is now close to equilibrium is still under question, the effects on exports and GDP of China are obvious.

However, as Chinese central bank launched the interest rate liberalization reform recently, I became more and more concerned about the future of China’s economy. Interest rates in China have long been pushed below the market equilibrium rate by the Central Bank in order to boost investment, which is the top driver of Chinese economy. Now, with the interest rate reform, the previous distortion in capital market will be revised by an increased in interest rate.  More and more hot money will flow into china, which will leads to an new round of appreciation of Yuan. If China ignored the upward pressure on Yuan caused by this inflow, the exports would be thwarted even more; If the People’s Bank of China intervene in the exchange market, the exchange rate would be stable, but would also adds to the China’s already massive pile of low-yielding dollar reserves.

This dilemma is hard to resolve. In my opinion, for China, a high yet unsustainable growth model has to be sacrificed in order to establish a healthier, more sustainable growth model. An export supported by low foreign exchange rate is never a solution for enduring economic growth. The dilemma China faced today is caused by historical fault and we should be brave to correct it. Therefore, both interest rate reform and foreign exchange reform are necessary.