I want to delve deeper into the technical points made in my BloombergViews piece. It is taken as gospel by that a lower RMB will wreak havoc, is unnecessary, or bad policy. However, as I will always come back to, pay attention to the details. We need to look closer to say that a lower RMB will harm China, the world, and bring out Godzilla to wreak havoc. There will be some, but let’s try and proceed somewhat carefully.
First, let’s discard with say one-third of Chinese trade. The reason is simple, this is roughly the amount that is related to processing trade. Processing trade is when China imports components, assembles them, and re-exports them in a different grouping. The best example of this is the iPhone. One study found that of the roughly $300 export value of the iPhone only about 3-5% of that was Chinese, even though the iPhone is stamped made in China. To make the iPhone, China will import components from all over the world, assemble them in China and re-export them. Consequently, processing trade is essentially immune to changes in currency prices. The only part China itself is selling is the labor required to assemble the iPhone. A lower RMB may mean higher component prices but then they make more money selling the final product, so there is essentially no change to profitability. In other words, about 1/3 of Chinese trade is pretty much immune from any change to the RMB.
Second, China imports lots of commodity products think iron and gas among others. The key issue here is how price sensitive are Chinese importers if the RMB goes down and imported prices go up? The likely answer is…not very price sensitive. There are numbers of reasons to believe this. For instance, Chinese certainly weren’t price sensitive when prices were at the peak for a number of years. If high prices didn’t slow import growth of these products, what makes us think that lower prices are going to kick start them? Furthermore, in a surplus capacity environment, there is little reason to think that import commodity prices are going to play a major role in investment. As has been widely noted, the high levels of investment that will eventually need to return to more normal levels will play a much larger role. Given also that many commodities here like oil, to continue to grow in volume on trend, there is little reason to believe that a lower RMB will have any significant impact on imports.
Third, almost 60% of Chinese exports are electronics and textiles/garments which are unlikely to be impacted much by RMB movements. Not only are large amounts of electronics processing trade, something we have already covered, but given that China produces the large majority of consumer electronics globally, it is going to grow with global demand not lower RMB. TV’s and computers for instance, China makes most of the global products in this area. Consequently, this will essentially track global demand not a single currency price. Same thing for garments and textiles where China has a more than 40% global export market share. It has such a large share of the market in these areas, it will track global demand for these products more than a currency devaluation will be able to help.
Despite all the press releases about China is moving up the value chain, it simply isn’t at least in international trade markets. How do we know this? Let’s look at a simple comparison of what China trades and the prices it gets for those products. For our example here, we are going to use steel products. China is both an importer and an exporter of steel products. In December 2015 China imported 1.2 million tons of steel and exported 10.7 million tons of steel. Wait though, there’s more to this story. China paid $1.2 billion for the imported steel and received $4.9 billion for the exported steel. Why does that matter? China was importing steel at $1,023/ton and exporting $459/ton. In other words, China was paying twice as much for its imported steel products as what it exported. Now the price difference is almost certainly due to qualitative differences in the products. This implies that China is importing high quality steel products and exporting low quality steel products, which could mean galvanizing or fabricating in some way.
The reason this matters is that developed countries have the least to fear from a falling RMB. China simply does not make the higher quality value added products that compete with the highest quality products globally. The countries that should be fearful are other emerging markets. Who is producing garments and other basic manufactured products? It is other south east Asian and increasingly, though not enough to impact global markets sub-Saharan African countries. Those countries may feel pain for sure, but there is little reason to believe it will have global consequences.
What is most amazing here is that the countries/firms that are likely to be most impacted by a changing China are already feeling it independent of any change in the RMB. Chinese imports of machinery are down (read German) as are some commodity products. However, most importantly I am referring to a change in commodity prices. In all fairness this is due as much to surplus capacity as it is to weak demand. I haven’t seen a good estimate of how much blame should be assigned to both sides, but there is undoubtedly some blame to go around.
Finally, it is worth noting that the financial flows between China and the rest of the world are limited. Consequently, it is unlikely that we would see large spillover effects. China still owes about $1 trillion in foreign debt, a large percentage of which matures this year. This is undoubtedly a not insignificant amount of money but should not trigger a financial crisis.
Leaving aside the potential impact of a lower RMB, I return to a couple of simple questions that are more strategic. First, what do you hope to accomplish by propping up the RMB, drawing down reserves, and/or tightening hard capital controls? I would love a good clear answer. Time? Time for what? Reform? Economic rebound? If it is problems you are trying to avoid, what problems? Looking at China or the rest of the world, there would clearly be some adjustment costs, but doom mongers about a lower RMB don’t seem to be making a case about a lower RMB. My first problem is that it is enormously unclear what the purpose of preventing a lower RMB is. If the argument for using FX reserves or imposing capital controls depends in anyway on “reform” or improved policy making from Beijing, I don’t want to hear it.
Second, it would seem to be worthy of preventing a fall in the RMB if there is a good probability of longer term success. Again, the argument to me seems utterly deficient. Let’s assume capital controls are imposed or reserves are used to prevent a slide in the RMB. What are the longer term chances of success? I’d have to say pretty low. I see little near to middle term (within 2016) probability that capital outflows will reverse. So let’s assume you burn through reserves trying to make everything seem fine and then decide in 2017 to float. What have you gained other than spending $1 trillion to delay the inevitable? Even there is a clear and decisive reason for maintaining the RMB at an artificially high value, I do not see the purpose of entering into a battle with certain defeat. This does not mean victory has to be assured, but it would seem foolish to prop up the RMB if the expectation is that policy will be reserved or removed within a year.
Right now, I am struggling to see why a lower would be the worst of possible outcomes before us.