Why today's Philly Fed report is not as strong as it seems
Today's figures from the Philadelphia Federal Reserve appear bullish at first glance, but a closer examination reveals some mixed signals amidst a decidedly end-of-cycle overall tone.
Head of Macro Analysis
In April 2018, a few days after the release of the US Treasury's semi-annual foreign exchange report, President Trump denounced the devaluation of the Chinese yuan on Twitter. Since his 2016 presidential campaign, Trump has been involved in a great bargain with China: by pointing out what he calls “China’s currency manipulation”, he hopes to force Beijing to reduce its large trade surplus, which represents about half of the US total trade deficit of about $500 billion.
Is the CNY undervalued?
Looking at the CNY exchange rate, it does not appear as if the currency is undervalued. Using JPMorgan’s REER index, which takes into account relative inflation between trading partners, the yuan has appreciated more than any other leading currency since 2010. The CNY has increased by more than 25% in that period, compared with 10% for the USD. Conversely, over the same period, the pound fell by 1% while the euro and the yen decreased by 13% and 25% respectively.
In 2017, against the backdrop of a Chinese economy slowing to a degree that would normally constitute a strong incentive to devalue, the yuan rose by nearly 7% against the USD; the reference basket of CFETS (in which the USD represents 22.4% of the total weight) has also increased.
Another way to assess the currency's valuation is to rely on purchasing power parity. As indicated in the International Monetary Fund's External Sector Report of July 2017, the yuan exchange rate is broadly in line with the country’s fundamentals while the US dollar is undervalued by 10% to 20%.
Between 2003 and 2014, China emerged as the champion of currency manipulation – but it was certainly not the only country in the running for that title. Over that period, it is estimated that Beijing bought more than $300bn/year in dollars to maintain its artificially low rate of exchange between the CNY and the dollar. This ultimately led to a major competitive advantage that largely explains the country’s huge trade surplus, which peaked at 10% of GDP in 2007.
Since the sharp 2015 devaluation, however, China has aimed (successfully, so far) to stabilise the exchange rate in order to meet its macroeconomic and financial objectives of moving from an export- to a consumption-based economy and internationalising the CNY.
Recent US calls to change the structure of the Chinese economy demonstrate Washington's ignorance. In China, the share of investment as a percentage of GDP felt from 47% in 2013 to 43% at the end of 2017, while that of consumption increased from 36% to 39%. In the long run, if China follows the path of most emerging countries, we can anticipate that the shares of investment and consumption will be close to 35% and 50%, respectively.
In addition, the export-oriented model is now less important for the Chinese economy. In fact, exports account for just 18% of China’s GDP, compared with nearly 35% in 2007. Last year, net exports contributed only 9% to GDP, which tends to confirm that they are no longer the main driver of Chinese growth.
It took time to achieve this long process, thus it seems unlikely that China will suddenly decide to take a step back. What the Chinese authorities understand is that the longer this economic transformation takes, the larger the question of debt sustainability looms.
The inexorability of de-dollarisation
The US-led trade war is fundamentally a currency war aimed at maintaining USD hegemony in the international monetary system. Believing, as has been said here and there, that China might decide to sharply devalue its currency in retaliation against US protectionist measures is a misinterpretation of Beijing’s strategy.
What is currently happening in the FX market is that easing measures from China are pushing relative rates down and increasing pressure on CNYUSD. China is not devaluing; Beijing understands that resorting to devaluation would be more damaging to itself than to the US.
In recent years, monetary stability led to macroeconomic stability. If this link is broken, it could destabilise financial markets and cause FX turmoil, as was the case in 2015.
This would also mark the close of the yuan liberalisation process that saw the currency's 2016 inclusion in the IMF’s SDR as well as the first yuan-denominated transactions in the oil futures market earlier this year. This last, small step is expected to have little impact in the short-term but it could completely change the structure of the oil market in the longer term provided that China reduces capital controls and its trading partners agree to be paid in yuan for oil exports (which is starting to be the case for Russia and Iran).
Although the internationalization process is still incomplete and will certainly take at least a decade, the yuan is gradually gaining status as an international reserve currency. As for the future of this process, we suggest looking to Africa: this is where the CNY's use could really jump in the coming years. Some Eastern and Southern African countries already favour yuan-denominated transactions due to China’s growing influence in business and trade on the continent. This explains the recent proliferation of currency swap discussions following the recent swap agreement made between the People's Bank of China and the Central Bank of Nigeria.
As we tried to highlight here, the real debate behind the ongoing trade war noise concerns the de-dollarization of the international monetary system and reserve currency diversification.