The market expectation of the Renminbi has reversed.  Instead of expecting permanent appreciation, an outlook of depreciation is gaining traction.  I think the yuan-dollar exchange rate will remain stable over the next twelve months.  However, both the RMB and dollar will likely depreciate against other currencies in 2009.  In 1998 the yuan-dollar peg played a stabilizing role, though they both appreciated against other currencies.  In 2009 the peg will again play a stabilizing role, though they will depreciate together.

Every emerging market currency comes under depreciation pressure after a bout of appreciation.  Emerging economies need cheap currencies (as in, the nominal exchange rate versus the purchasing power parity exchange rate) to develop, because they need to attract investment with future appreciation potential to offset the risks in emerging economies).  The emerging market discount declines when an economy becomes more developed.  The lower the per capita income, the cheaper the currency.  From time to time we have emerging market euphoria to upset this relationship.  The concept of BRIC became the focus of euphoria in the past three years.  All sorts of theories were invented to justify the appreciation of their currencies.  The enthusiasm turned into speculation as speculators borrowed yen and dollars to buy assets in these countries.  Their currencies appreciated under the pressure.

 

The story, as in previous emerging market bubbles, has turned out to be dollar-driven.  The dollar went into a bear market in 2002.  The dollar index dropped from 120 in 2002 to 79 in 2004, or 34 percent depreciation, staged a mild 15 percent recovery between 2004 and 2006 on the Fed rate hikes, and dived afterwards on declining property prices to a low of 72 or 40 percent from the peak early in 2008.  The dollar index has staged a vigorous rebound since July to a recent high of 88 or 20 percent, up from the bottom.  It seems that the driver for the dollar's strength is deleveraging in emerging markets, rather than good news from the United States. Much of the dollar’s weakness since 2006 was due to the popularity of derivative products that essentially borrowed dollars to buy emerging market assets.  For example, the 'Accumulator', aka 'I kill you later', may have borrowed $100 billion US dollars to buy Hong Kong-listed Chinese stocks.

 

The unusual strength of yen is another sign that the driving force in the currency market is deleveraging.  Yen was more popular than dollar as a funding currency for speculation in risk assets due to its low interest rate.  Yen has strengthened against the dollar during the latter's rebound.  The cross of yen-Australian dollar has collapsed by half in 2008, reflecting the popularity of borrowing yen to buy high yielding Australian dollar.  

 

Emerging market currencies have gone back to their 2006 levels.  Some, such as Korean won, have gone down further due to domestic problems.  In contrast, the Chinese yuan has stayed up.  At the same time China is more dependent on exports and, hence, is more affected by the current downturn than other emerging economies.  Ceteris paribus, the Chinese yuan should depreciate along with other emerging market currencies.

Further, China's monetary easing has further to go than other economies.  China's deposit reserve require ratio ('RRR') at 16% has a long way to fall.  As the RRR falls, RMB supply will rise.  At present the banks are unwilling to lend.  Like in the United States, monetary loosening is merely causing liquidity to pile up within the banking system without increasing lending.  But, as the fiscal stimulus gets into full swing next year, banks will lend to government projects.  The RMB value would come under more pressure then.

 

China is still running a substantial trade surplus, which should support the currency.  But the surplus may decline substantially in 2009.  The increase in trade surplus now is due to imports falling faster than exports, which reflects weak investment desire and, hence, less capacity for exports next year.  Hot money is also unfavorable.  The stock of hot money in China's banking system is hard to estimate.  It is probably hundreds of billions.  When the economic situation is as poor as now, it should probably flow out.

 

Unlike in 1998, emerging market currencies won't collapse this time.  Emerging economies had fundamental dollar shortage back then.  They invested their borrowed dollars inefficiently and had to write off their investments through devaluation.  With some exceptions emerging economies don't have dollar shortage in the current crisis.  They have been running large trade surpluses for ten years and have large foreign exchange reserves.  On the flow basis, there isn't a strong case against their currencies.

From the U.S. side the fundamentals for the dollar are deteriorating.  First, despite a very weak economy, the United States continues to run around $50 billion trade deficit per month.  When a bubble bursts, the trade deficit should shrink quickly.  I expected this for the United States early in 2008.  This is just not happening. The persistent trade deficit is a negative factor for the dollar.

Second, the returns on dollar-based assets are quite low.  The price-book ratio for S&P 500 is 1.7, far higher than the average of 1.3 for other markets.  Against its historical average of 2 the 15 percent discount is probably insufficient to compensate for the risk during a financial crisis.  The price-book ratio of S&P 500 averaged 1.3 during the bear market between 1972 and 1982 and 1.1 between 1932 and 1952.  The U.S. stocks are just not attractive from historical perspective or against other markets.  On the fixed income side, the short term rates are quite close to zero across the board.  The 10-year treasury is only yielding 2.6 percent.  Indeed, the treasury market is probably a bubble as panic causes money piling into this market.  Only distressed assets in the US may be attractive in 2009 as financial institutions unload the assets on their books.  This market will not be big enough to offset the unattractiveness of the United States’ stocks and bonds.

Third, the United States will have a huge budget deficit.  Excluding aids for the ailing financial institutions, the U.S. Federal government will incur over $1 trillion in budget deficit.  The supply of treasuries will flood into the market as soon as the Obama Administration comes in.  The United States won't have enough money at home to support this market.  The need to attract foreign money will put pressure on the dollar.

The dollar was strong in early 1980s when the United States ran large twin deficits.  But, the dollar was supported by very high interest rate.  The Federal Reserve then raised the Fed funds rate to double-digit rate to crash inflation.  In contrast the Fed is cutting the Fed funds rate to nearly zero and is talking about quantitative easing.  The combination of low interest rate and twin deficits will cause the dollar to weaken in 2009.  Indeed, I think that the dollar may make a new low within two years, i.e., the dollar index dropping below 71.

The outlook for the RMB depends very much on how the dollar trades against emerging market currencies.  China obviously has a competitiveness problem.  Its vast export sector has had profit problem for the past three years.  The demand collapse now is forcing numerous exporters to close.  The economic pain is acute.  At the same time the vast property development industry is also coming under acute pressure.  It has expected price and sales to surge.  The reality is that the price may need to decline by 30 to50 percent to sell the inventories.  If the RMB continues to appreciate, it would put further pressure on the price.  Hence, unless the dollar reverses its direction, RMB depreciation may become inevitable.  This is why I am talking so much about the dollar direction here.

The market factors, of course, don't always decide.  Government, even if only temporarily, can use its power to move exchange rate its way.  China has $2 trillion in foreign exchange reserves.  If it wants to defend the exchange rate, it has enough ammunition to stave off market force for a long time.  Hence, it is important to understand the government's considerations.

Chinese government has shown a preference for a strong currency since 1994, at least in relation to the dollar.  In 1994 China abolished its dual exchange rate system and set the combined exchange rate at 8.9 against the dollar.  It slowly appreciated to 8.3 by the end of 1997.  When the Asian Financial Crisis hit, China resisted devaluation.  The government argued that a Chinese devaluation would set off another round of competitive devaluation, which would hurt China eventually.  The exchange rate was kept at 8.3 until 2005.  Under political and market pressure, the government appreciated the RMB’s value gradually to 6.8 against the dollar.  The upward trend stopped three months ago when the problems in the export sector became explosive.

The case against devaluation made ten years ago is even stronger today.  China's exports have probably become the largest in the world this year.  A Chinese devaluation would certainly set off competitive devaluation by others like Korea and Southeast Asia. China may not gain much from devaluation.  Further, devaluation won't fix the demand problem.  The global economic crisis has to run its course.  China will suffer during the process even if its currency is devalued.  On the cost side, devaluation will help export businesses to survive.  But, their survival may not last.  China will likely lose big chunks of shoes, furniture, and garment businesses to Bangladesh, Indonesia and Vietnam.  China has lost competitiveness in these industries.  Devaluation can only delay the exit of these industries from China.

 
China's economic difficulties can be alleviated by fiscal stimulus and solved by economic reforms and global economic recovery.  The room for fiscal stimulus is still plentiful.  The proposed issuance of Rmb 500 bn fiscal bonds (1.6 percent of GDP) is at the low end of my expectation.  It should be doubled as soon as possible.  A big chunk of the proceeds should go to support laid-off workers.  Migrant workers who work for export businesses are forced to go back to their home provinces after they are forced out of their company dormitories.  The exodus is putting enormous pressure on interior provinces that have little fiscal resources to deal with the situation.  The central government should put in a temporary relief for these workers through a special budgetary allocation.  It should be done as quickly as possible to prevent a social crisis.

Devaluation won't solve the employment problem at all, I believe.  It may trigger hot money to leave and deepen the property market downturn, which would decrease demand for migrant workers.  A big chunk of the fiscal stimulus should be used for cash subsidies for property purchases.  First, the government should give cash subsidies to households who are qualified for low cost housing to purchase in the commercial market as Hunan province is doing.  Second, the government can subsidize three percentage points in mortgage interest rate.  Third, property purchase cost should be made tax deductible.  All three benefits should go to first time buyers with caps on total purchase prices.  If these policies are put in place, they can support the labor market far better than devaluation.

Chinese government has a natural desire for maintaining the dollar-yuan cross during a crisis.  It has plenty of room on the fiscal side to support the economy.  And a devaluation may have unintended consequences to worse the labor market.  From these considerations the government is likely to defend the exchange rate when under pressure.  It has the resources to withstand conceivable market pressure in the foreseeable future.

Chinese government may support the RMB depreciation if the dollar rises substantially from the current level.  Its probability is quite low, I believe.  The reduction of dollar leverage among emerging markets has supported the dollar's strength in the past four months.  The financial and economic situation in the United States will remain more challenging than elsewhere for the foreseeable.  When the dollar leverage in emerging economies is all unwound, the dollar should decline again, which will remove the depreciation pressure on RMB.