Pettis on why the yuan is falling

Exclusively from Michael Pettis’ newsletter:

It is pretty clear that the PBoC was mainly out to wrong-foot speculators including, perhaps most importantly, SOEs who have written a huge number of naked RMB puts (on the assumption, I guess, that the premiums were all free income). In addition there are a lot of outstanding derivatives (target redemption forwards, for those who care) that create a tremendous self-reinforcing surge of downward trading once the RMB breaks certain levels, and the central bank would probably like to clear out some of the derivative products that create systemic risk.

…First, and most obviously, the RMB is not overvalued. Looking at just the change in the value of the currency over some period is meaningless because China’s export competitiveness is based as much on low wages and cheap financing as it is on an undervalued currency, but in any “normal” world, in which China was growing at 7-8%, unemployment was low, and debt rising, while the rest of the world was barely growing, and was deleveraging amidst high unemployment, China should be running a huge deficit while the rest of the world ran a huge surplus.

More importantly, however, is the rebalancing process. Depreciating the currency will not increase household income. It will raise the cost of imports, including energy and food, and so reduce the real value of household income. Choyleva argues that once you exclude reprocessing, imports are relatively low in China, in which case the benefits to households are also low, but I look at it very differently. Revaluing the currency by, let’s say, 10% will cause the PBoC to book a loss of roughly 5% of GDP. This loss, as I explained in my book, is not a loss for China but mainly part of a transfer of wealth from those sectors of the economy that are effectively long dollars (the PBoC, exporters, and wealthy Chinese with foreign assets) to sectors of the economy that are effectively short dollars (importers and households)…

What is more, by reducing household income while boosting the tradable goods sector, devaluation will force up China’s already too-high savings rate. The idea that a depreciating RMB will make Chinese spend more because they will benefit from a wealth effect as their foreign assets appreciate in value assumes that ordinary Chinese already own a huge amount of foreign assets. They do not…

If the RMB were to depreciate we would need even higher wages or interest rates than we otherwise would in order to force up the household income share of GDP, and I think it would be a huge mistake to sacrifice the interests of both the capital- and labor-intensive sectors in order to make life easier for the tradable goods sector. We need more service industries and high-tech industries in China, not more toy manufacturing.

But perhaps the strongest argument for the PBoC is the capital flight argument. I suspect the only thing keeping net inflows into China so positive is the carry trade, in which higher relative interest rates and the expectation of continued appreciation causes Chinese companies to bring (often illegally) large amounts of money into the system (of course at the expense of the PBoC, who must carry the other side of the trade).

All this inflow isn’t a good thing, of course, but once you kill the carry trade, the risk is for an enormous outflow of capital that could devastate the banking system.