by Elliott Morss
At the recent G-20 meetings, US Treasury Secretary Geithner argued that the RMB was undervalued (read US$ overvalued). He said we need a better set of incentives to promote external sustainability and reduce the risk of the re-emergence of large trade and current account imbalances. He pushed for a set of “indicative guidelines” on appropriate currency valuations. China did not buy it. Several journalists reported that the talks collapsed before the meetings had wrapped up. China does not like to be pushed around, and it wants to keep the dollar strong to support its exporters. So what do we know about US$ values? Read on.The Weakening US$
Since the US started to run large trade deficits in the mid-‘nineties, the US$ has weakened considerably. Table 1 provides data on how much value the US$ has lost against a number of currencies since 1995.
Table 1. – US$ Value Loss, 1995 – 2011
China Yuan Renminbi
United Kingdom Pound
Most of losses have occurred gradually over time. But the 21% loss against the RMB has happened since over the last 5 years as the Chinese have done slightly less to keep the US$ strong.
How Far Out of Line Are the Rates?
Economists have several empirical methods to estimate what exchange rates “should be”, and none of them are perfect. They work quite well when the only imbalance involves goods traded. But for both the US$ and the RMB, things are particularly difficult.
The US$ is used for more than just US trade. It is the global currency, with 85% of all foreign exchange transactions involving US$. And US securities have held great appeal for foreigners, sometimes as a safe haven (US government securities) or as a capital gains vehicle (US equities). This means that neither the US trade nor the current account deficit is an appropriate measure of how overvalued the US$ is. In addition, the current account includes goods, services, and income. The US runs a big deficit on goods, but has a surplus on both services and income.
The China situation is also complex. For many years, the Chinese government has tightly controlled how its currency is used. To support its exporters, the Government has regularly purchased large amounts of US government securities. According to the latest Treasury estimates, it now holds $1.2 trillion of Treasury debt.
For the G-20 meetings, the IMF published a document that included Table 2 below. It includes estimates using three different methodologies (MB – Macroeconomic Balance, ERER – Equilibrium Real Exchange Rate, and ES – External Stability are three methods used by the IMF to judge exchange rate imbalances.
Table 2. – G-20: Assessment of Real
Effective Exchange Rate, 2010
The IMF does not make public its country-specific estimates. The countries included in each region are as follows:
- Advanced countries: U.S., E.U., Japan, U.K., Canada and Australia;
- Asia: China, Korea, Indonesia and India;
- Latin America: Brazil, Mexico and Argentina, and
- Other: Russia, Indonesia and India.
1. On Advanced Countries:
The real effective values of the euro and the Japanese yen are broadly in line with medium-term fundamentals, while the U.S. dollar remains on the strong side of fundamentals. Some further real effective depreciation of the U.S. dollar would help ensure a sustained decline of the U.S. current account deficit towards a level more consistent with medium-term fundamentals, helping to support more balanced growth.
2. On Asia:
…some major Asian central banks have accumulated reserves and kept currencies undervalued, contributing to continuing significant exchange rate misalignments relative to fundamentals, and hampering progress towards global rebalancing. For instance, the Chinese renminbi continues to remain substantially undervalued in real effective terms.
Table 2 data plus the above comments lead me to guess that the IMF believes the US$ is overvalued by approximately 15% relative to the RMB.
Barry Eichengreen recently wrote an interesting article in the Wall Street Journal pointing to the multiple uses of the US$ (the liquidity of $-denominated debt, as a “safe haven”, and as a transaction currency). He pointed out that each of these uses requires more $s in circulation than if it was just used for US trade transactions. He predicts that in the coming years, the EUR and RMB will assume some of these roles:
Foreign investors will be reluctant to put all their eggs in the dollar basket. At a minimum, the dollar will have to share its safe-haven status with other currencies.
…the dollar will have to fall by roughly 20%. Because the prices of imported goods will rise in the U.S., living standards will be reduced by about 1.5% of GDP—$225 billion in today’s dollars. That is the equivalent to a half-year of normal economic growth. While this is not an economic disaster, Americans will definitely feel it in the wallet.
I will limit my thoughts to the US$ versus the RMB. And for this, some country-specific facts should be noted.
China is viewed as the global powerhouse that can produce anything cheaper than anyone else. But it should also be remembered that China is fundamentally a natural resource poor country with a rapidly growing middle class. At home, it is running out of coal and is building nuclear plants as fast as it can. It is going all over the world to buy food and oil for its growing population.
The staff at McKinsey and Co. has been China watchers for many years. In 2006, they published a report titled “From Made in China to Sold in China: The Rise of the Chinese Urban Consumer”. More recently, they looked at China exports using a value added approach and concluded that exports accounted for 19% of China’s total growth in gross domestic product–far less than the level commonly assumed. The reason for this lower number is that China must import a significant amount of the value of goods that will be later exported. The study concludes that exports –
– have been an important driver of China’s growth, but not the dominant one….Most common wisdom overestimates the role of exports while underestimating the role of domestic consumption for China’s growth.
What does all this mean? China’s massive trade surplus will fall down significantly over the next few years as China imports more and more to satisfy its growing middle class.
b. The US
On top of the ever-growing bill for oil imports, the improvement in the US economy will contribute to a growing US trade deficit. And for at least the next two years, the US government deficit will exceed $1 trillion. Consider now the following table from a recent article detailing US capital flows.
Table 3. – US International Financial Flows (bil. US$)
Type of Investment
U.S. Foreign Investments
Direct investment (current cost)
Other US Private Claims
Foreign Investments in U.S.
U.S. Treasury securities
Other U.S. government securities
Other Net Claims
Direct investment (current cost)
U.S. Treasury securities
Other US Securities
Source: US Bureau of Economic Analysis
Going forward, the key row in this table are foreign governments buying $481, $551, and $450 billions of US government securities in 2007, 2008, and 2009, respectively. The largest buyer? China. Will this continue? China is under a lot of pressure to let the RMB appreciate. Buying US$ securities is one of the methods it uses to prop up the US$.
What if it stops buying? A very important positive US capital flow element will be lost, and the US$ will weaken. In addition, with China out of the market for a major component of government securities, who will take its place? Who will buy US government securities at such low interest rates with such large government deficits on the way? The Fed could do another round of quantitative easing….
The US$ will weaken by 10% in the next 12 months. I do not see how it can be avoided. If you have foreign investments via ETFs or mutual funds, you will realize capital gains from the weaker US$ when you liquidate these holdings.
The weaker dollar will help US exporters. In addition, it should foster additional investments in US manufacturing.
G-20 Meetings: Bernanke on Capital Flows by Elliott Morss
Elliott Morss has a broad background in international finance and economics. He holds a Ph.D. in Political Economy from The Johns Hopkins University and has taught at the University of Michigan, Harvard, Boston University, Brandeis and the University of Palermo in Buenos Aires. During his career he worked in the Fiscal Affairs Department at the IMF with assignments in more than 45 countries. In addition, Elliott was a principle in a firm that became the largest contractor to USAID (United States Agency for International Development) and co-founded (and was president) of the Asia-Pacific Group with investments in Cambodia, China and Myanmar. He has co-authored seven books and published more than 50 professional journal articles. Elliott writes at his blog Morss Global Finance.