1) By many measures the Chinese yuan is overvalued, or at a bare minimum fair-valued. Real effective exchange rates (REER) - inflation adjusted exchange rates against a basket of trade partner currencies - indicate that the yuan is possibly the most overvalued major currency in the world. As seen in the chart below, on a five-year basis, the yuan is 40% overvalued.
REER Percent Difference from 5 Years Prior
Other market forces point to an overvalued yuan. Chinese mainland and foreign investors have been moving capital out of the yuan at a rapid pace, indicating there is greater value to be had in other currencies. The economy has been in a state of outflows since spring this year, forcing the PBOC to liquidate foreign currency reserve assets to compensate.
A number of organizations that once put a spotlight on Beijing’s use of a cheap yuan to boost trade have argued recently that the yuan is undervalued no more. In May, the IMF declared that the yuan is no longer undervalued after years of criticism. The Peterson Institute as well has argued against the notion of an undervalued yuan recently, after charging that the currency had been undervalued as few as 3 years ago.
So, how has the yuan - a heavily managed currency used in the past to support Chinese exports and industry - turned into an overvalued currency? Beijing changed the currency policy in 2005, allowing the yuan to slowly appreciate. For the last decade, the yuan has been a one-way bet, appreciating over 30% vs. the US dollar. Policymakers have been biased towards a strong yuan for years to facilitate rebalancing. An undervalued currency once helped Chinese industry immensely, but at the expense of adding to financial repression - whereby households subsidized industrial growth through low savings rates and imported inflation from a cheap currency. A stronger yuan has been a tool to roll back decades of imbalances, and to that end we should not expect Beijing to reverse course without a major and unexpected drop in output. A stable, strong yuan is an important tool for rebalancing and reversing financial repression and we should not expect Beijing to suddenly shift gears to a meaningful devalue.
2) The yuan will likely become fully convertible within the next five years. Chinese leaders recently have promised full yuan convertibility by 2020. Historically, capital market liberalization and free-floating a currency are often risky and messy reform moves for developing countries, which eventually pay off for an economy in the long-run. Giving up control of the currency is particularly difficult for policymakers that have used the significant control over the yuan as a policy tool to steer the economy, first driving down the value as a catalyst for industrial growth, and then letting the currency rise to facilitate rebalancing.
So, I would expect the next five years of opening the capital account and floating the yuan will be characterized by bouts of turmoil, some significant currency interventions, and occasional temporary roll-backs of market freedoms. But, Beijing will push forward; open capital markets and a free-floating yuan are a necessity for long-term global ambitions and domestic economic health.
Because China has the third largest bond market and second largest equity market in the world, expect China to be a major weight in just about every major global investment index within the next five years as the yuan is liberalized - EM bond and stock indices in particular.
3) The yuan’s importance is growing fast. The yuan’s use in global transactions is rising rapidly, and that pace will accelerate with capital market liberalization.
In 2013 China overtook the US as the largest trading nation in the world, accounting for 11% of global trade in 2014. Beijing is making efforts to expand yuan settlement of that trade. In October, the yuan overtook the Japanese yen as the fourth most used currency for global payments with 2.8% of the total, up 9% from last year. The yuan has a 9% share of global letters of credit. The number of financial institutions using yuan for global payments rose 14% in 2015.
As China further opens up its capital markets to outward and inward investment money flows, transactions will accelerate. The country has the second largest stock market and third largest local bond market in the world, potential targets for inflows. Chinese savings deposits are over $20 trillion, roughly 200% of GDP. Those savings are primed to seek out investments around the world as outflow restrictions diminish with reforms.
4) The Chinese yuan will be a major reserve currency in the long-term. Beijing has tandem plans in place to realize ambitions for making the yuan a major reserve currency - for both economic reasons and geopolitical ambitions. Policymakers have lobbied the IMF for inclusion in the Special Drawing Rights (SDRs) - a basket of four currencies used as an international reserve asset - as well as slowly set about liberalizing capital flows.
Recent comments by IMF chief Christine Lagarde indicates that China has succeeded in SDR lobbying efforts, and will be voted in at the end of the month. However, Beijing’s end goal is not to become a small slice of the $280 billion SDR basket. The end goal is to be a large slice of the $11 trillion reserve currency asset market. The IMF endorsement will be seen as an official nod for central bankers to increase yuan assets in foreign currency reserves. As yuan-denominated trade and financial transactions around the world increase, central bankers will increase yuan holdings in reserves.
However, China will need a much deeper and larger government bond market to unseat the USD as the world's preeminent currency (see below). China's entire bond market is roughly $5 trillion, compared to the $36 trillion US market.
Currency as a Percent of Global Fx Reserve Assets
5) Beijing will try to maintain meaningful control over the yuan for its reform agenda. Regardless of how free the yuan is allowed to float, Beijing will attempt to maintain heavy control over the yuan as both a tool for restructuring the economy and protecting against the risks of opening up capital markets. The yuan is a policy tool that Beijing will be unlikely give up completely. For the last decade, Beijing policy has pushed for a strong and stable yuan vs. the USD. This year we have seen rapid appreciation vs. major trading partners. Only in an unusual circumstance will Beijing let the yuan decline meaningfully.
Beijing can manage the currency much better than the recent mishandling of equity markets for two reasons. First, over three trillion USD worth of currency reserves will allow China to intervene on the side of a strong yuan, regardless of the duration and extremity of outflows. The reserve currency war chest is unprecedented, even after this year's liquidations. Second, Beijing policymakers have control over central bank activity and can print money and intervene to push the yuan down at will - but they risk stoking inflation and rolling back reforms as a result. China can do what it wants with the yuan, regardless of market pressures.
I cannot give investment advice nor market advice due to restrictions set by my current employer. But, I will say that we can expect to see a tug-of-war play out in the short and near-term between market forces putting downward pressure on an overvalued yuan, and policymakers looking to keep the currency stable and strong for economic restructuring purposes. As a result, we will continue to see the occasional PBOC intervention, more volatile foreign fx reserve activity, but probably only modest ups and downs.