“Get me an economist octopus…”

Harry Truman famously once said that he wished he had a one-armed economist because he could never get a straight answer from any of them – they were always going on about “…on the one hand…”

Upon returning to school this August I was immediately set upon by several colleagues who wanted to know how they should have their salaries designated (= ‘set’ or ‘assigned’) for the coming school year, in Chinese Yuan (RMB – Renminbi, “the people’s currency”), in US dollars, or a mixture of both. Luckily I had just been studying this very issue in great depth and was able to give them the rock-solid and unequivocal (clear-cut, decisive) sort of answer for which we economists are so famous: “I don’t have a clue. Do what I do; guess and go for safety. Chose 50/50.” I mention in passing that some of said colleagues are 90 kg hockey players who have muscles in their eyebrows – one might not want to flippantly offer advice or predictions that turn out to cost them lots of money. Just a thought.

After a few snide comments from the history teacher along the lines that US president Harry Truman had a point about economists, the colleagues were civil enough to sit through my defense/explanation later on over a few beers. Here is the basic question together with my theoretical underpinnings…and why I took the coward’s way out!

(Note how efficiently I use this blog post; I go through core/mainstream economic theory for you the student…and I am also going to send the blog link to every single colleague here at school. This is called ‘face-saving’ – or maybe petulant self-defense.)

I have written about exchange rates earlier so let us be swiftish with the basics. The exchange rate is simply the price of one currency in terms of another – and the rate is determined by the global market forces of supply and demand. The price of a US dollar (USD) in terms of the RMB is currently USD1 = RMB6.14 (or, inversely, RMB1 = USD0.1628). How is the rate set? Well, market forces set the price for the large part. For example, if more firms wish to invest in China they will need the RMB – demand for RMB rises and the price of the RMB rises [appreciates] – say from USD0.1628 to USD0.17 to the RMB (or, inversely, the dollar falls [depreciates] from RMB6.14 to RMB5.88 per USD). Also, if more Chinese RMB goes abroad to the US then there is an increase in the supply of the RMB and a depreciation of the RMB.

Here is what is at stake for the colleagues. Salaries are contractually set in USD but teachers are then paid in RMB and allowed to either ‘fix’ the exchange rate at the start of each year at the current USD/RMB rate or let the rate float. In other words, if one thinks the USD will appreciate against the RMB one should choose a floating rate – as the contractually set dollar amount will mean more RMB when exchanged and put into teachers’ accounts as RMB. Conversely, if one believes that the USD will weaken against the RMB one should chose to fix the exchange rate at the outset of the year – at RMB6.14 to the US dollar – in order to retain this exchange rate over a year where the dollar is losing value against the RMB. Finally, if one has no blinking idea or one happens to be an economist, one can chose 50/50, i.e. half fixed at the current exchange rate and half floating.

It is in dealing with uncertainties over longer time periods that problems with predictions arise – and why we need an eight-armed economist! Centrally planned economies are also notorious for government/central bank intervention on currency markets in order to maintain or adjust exchange rates. The figure above shows how the RMB was rather rigidly fixed to the USD up to 2010. After that, the government seemed to allow a ‘managed appreciation’ of the RMB (red line of best fit)…but this then came to a screeching halt over the course of the last year (green line). Without going into a tiresome itemization of Chinese interventionism on the currency markets over the past year, it is clear that there are strong political reasons for wanting a weaker RMB; a weaker RMB means cheaper exports – which in turn means greater aggregate demand and higher growth rates in the Chinese economy.

Now, this is about the colleagues and myself attempting to predict what will happen to the RMB exchange rate over the coming year. There are some good lines of reasoning for an appreciation of the RMB:

1. Marked – albeit sluggish – recovery in the US and Eurozone. Higher demand for Chinese goods and thus increased demand for the RMB.

2. The (increasing?) risk of a property bubble helps keep interest rates up and this attracts deposits from abroad, which in turn increases demand for the RMB.

3. Expectations! There seems to be a much stronger sentiment on the foreign exchange market that the RMB is undervalued. One can anticipate continued speculation that the RMB will appreciate – in effect creating a self-fulfilling prophecy where speculators’ expectation of a stronger RMB leads them to buy and thus increase demand for the RMB. I have read that circa 60% of short run volatility in exchange rates is due to speculation so this is perhaps the strongest argument in favour of a stronger RMB.

However, there are some equally solid lines of reasoning outlining a depreciation of the RMB:

1. Inflation has fallen and levelled off at below the 3.5% mark set by the Chinese government. This allows lower interest rates and thus a decrease in demand for the RMB.

2. The Chinese government is highly unlikely to allow a rapid or substantial appreciation of the RMB. In simple terms, an appreciation of the RMB and the resulting loss of export revenue will damage growth. The Chinese government simply cannot afford the public unrest resulting from millions of unemployed workers returning to the countryside as a result of decreasing demand for labour. In my opinion, this is one of the strongest arguments. The sight of 20 million labourers trudging back to villages in 2008 during the onset of the ‘Great Recession’ is something policy-makers in China are not going to forget.

3. The “shadow banking” sector in China – e.g. unofficial lending institutions that government cannot control – has boomed in the past year. Estimates of the size of the shadow bank system range from 30% to 60% (!) of Chinese GDP. A credit bubble, coupled with a housing bubble, makes for very high ground to collapse from! Such a crisis would have serious implications for inward investment flows to China and cause a rapid downward adjustment of the exchange rate.

To cap it all off, a recent rather high-profiled report from the Peterson Institute (www.piie.com/publications/pb/pb14-16.pdf) makes a strong case that the RMB is basically in what might be considered “equilibrium” – i.e. at a fair level value against the USD.

Basically the water is so muddied by conflicting possibilities that it is almost impossible to make a prediction…wait, it’s actually better to say that there are too many reasonable predictions possible that conflict each other for any ‘most reliable’ prediction to jump out! I won’t be betting any of my savings on the foreign exchange market for RMB, that’s for sure.