Pondering Chinese revaluation

In the long run nominal exchange rates should not (do not?) affect real exchange rates.  In other words, the yuan may be 2 percent stronger, but Chinese exporters can lower their prices 2 percent, if they so wish.  Now in the short run many prices are sticky, but does this really apply to Chinese exporters?  Haven’t we all had enough time to digest the possibility of yuan revaluation?

Do not neglect the effects on the capital account.  Perhaps the market expects further yuan revaluations; this would mean an increase in the nominal interest rate spread on dollar and yuan assets.  Yes this could bite domestically in the U.S. but so far we haven’t seen significant interest rate pressure.  In fact the day of the revaluation, the market showed an expected six percent gain for the yuan over the next year.  This hasn’t caused anything to come crashing down.

Or you might think the yuan revaluation changes market psychology, or redefines a focal point, and thereby signifies some long-run shift in future currency swings.  But if so, again the marginal trader in the market doesn’t think this is a big problem.

Also keep in mind that true Chinese liberalization would mean that Chinese private investors could buy many more dollar-denominated assets than is currently the case.  Maybe you’re worried about the Chinese central bank ceasing to buy dollars.  I’m more worried about Chinese liberalization leading to a domestic financial collapse, in part driven by capital outflows.  Of course, in any case I do not expect Chinese liberalization anytime soon.

The bottom line: Many approaches to exchange rates focus on various financial flows, and what adjustments must occur to make them balance out in the medium-run.  It then seems the dollar must fall drastically to restore our trade balance.  I’ve never been impressed with the predictive power of these models.  Look at national wealth instead: the U.S. still has by far the healthiest economic situation in the world, so why should the dollar be due for a crash?  I expect China to face a financial crack-up plus their long-run demographic problems are daunting, perhaps the worst in the world.  So the currency market is overlooking one set of "fundamentals arguments" to focus on even longer-run fundamentals.  As is so often the case, it is the noise traders who are enforcing an equilibrium based ultimately upon the very long-run fundamentals.

But if you wish to read the case for worry, check out this WSJ Econo-blog.  Brad Setser adds commentary.


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