China vs. US... round 574322

So some American senator's are once again trying to pressure China to cause the RMB to appreciate, by various diplomatic and legal means. That's nothing new. But how can we be sure that the RMB is undervalued? The simple truth is that we cannot.... and there are compelling reasons to believe that the RMB may actually be OVERVALUED at the current time.

What we know is that at the existing exchange rate, RMB demand exceeds supply. The People's Bank of China responds by selling RMB in exchange for USD and other currencies. If this was the full story, then we could make a strong case that the RMB is selling for below its market value, and is therefore undervalued.

But in the case of China, we do not actually observe the underlying market supply and demand for currency. That is because the market is heavily distorted by capital controls. Investors in China cannot freely invest in other parts of the world. This does not only reduce capital outflows, but capital inflows as well, as outsiders may be less willing to invest money in an economy from which it may be difficult to extract the investment later.

I would argue that the underlying equilibrium value of the RMB is the value that it would take, absent capital controls. And if China were to remove capital controls today, both capital inflows and outflows would likely rise. The former would put upward pressure on the RMB, while the latter would put downward pressure.

Which one of these is likely to dominate? The best place to look for this is the presence of distortions in asset prices. If controls are disproportionately discouraging inflows of capital, China should be a sea of promising investment opportunities that offer higher risk-adjusted returns than those available elsewhere. In contrast, if capital controls are disproportionately discouraging outflows of capital, too much money will be chasing too few assets in China, driving up asset prices and therefore driving down asset returns.

We don't need to look any further than the arbitrage opportunities that exist between H-shares and A-shares to find compelling evidence that the RMB may be OVERVALUED. Based on equivalent shares trading in both Hong Kong and Shanghai, Chinese asset prices are approximately 3 times higher than they would be without capital controls. A correction in asset prices sufficient to remove this arbitrage opportunity would likely require a massive capital outflow, and with it a large depreciation of the RMB in the short run.

Prediction: just as with all earlier rounds, the senators will once again lose this round with China.

(For an excellent analysis of the underlying economics of the RMB/US exchange rate, check Menzie Chinn here.)