America has seen bilateral competitiveness against China improve through a mix of yuan appreciation and a substantial change in relative unit labor costs. The yuan is close to being fairly valued against the US dollar. This marks a fundamental change in the global economy and has profound investor implications.
Chinese central bank officials suggest that the renminbi is now close to fairly valued. But China has denied the undervaluation of its currency for so long that much like the boy who cried “Wolf”, no one may pay attention now. But this time it is different! The US has seen bilateral competitiveness against China improve substantially in the past six years through a combination of yuan appreciation and Chinese inflation. Not much more is needed to complete the necessary US real exchange rate rebalancing.
Beijing created a dollar zone when it pegged the yuan to the dollar. In 1994 the fixed rate reflected China’s competitiveness, but between 1994 and 2005 bilateral competitiveness moved sharply in China’s favor as Chinese unit labor costs fell while American unit labor costs rose. Beijing resisted allowing the nominal exchange rate to rise, but eventually could not impede the necessary real exchange rate adjustment. In such a zone the overvalued side will tend to deflation and the undervalued part to inflation, and this is what happened. In July 2005 Beijing allowed the yuan to start rising against the dollar and by mid-2008 it had gained 18%; but, with China’s consumer price inflation accelerating fast and its current account surplus surging, this was insufficient. The global financial crisis provided China with a temporary relief from inflation at the expense of recession and the onus of the adjustment was shifted to US deflation. Beijing’s response to the global financial crisis was re-fixing the yuan to the dollar in mid-2008 and then a massive monetary stimulus in 2009-2010. The result was renewed Chinese inflation. The US, fearing the onset of deflation, also tried to stimulate its economy. The Fed’s second round of quantitative easing (which helped devalue the dollar) pushed the adjustment further onto Chinese inflation, which peaked at 6.5% in mid-2011. The yuan was allowed to start rising in mid-2010, but not by much. But the adjustment in terms of labor costs was progressing fast.
Bilateral cost competitiveness between two countries is a blend of currency movements and the change in relative labor costs. China’s wage inflation picked up speed not only on the back of the massive stimulus but also because of a structural shift towards dwindling cheap migrant labor and lower productivity growth. China’s unit labor costs measured in US dollars have risen by about 21% in 2007-2011, while US unit labor costs rose by just 0.6% during the same period. So the US has seen bilateral competitiveness vis-à-vis China already improve by over 20%. Starting from the premise that the yuan was fairly valued against the US dollar in 1994, the US has now clawed back most of its competitive advantage as the deterioration in US competitiveness in 1994-2007 was about 26%.
The relative cost adjustment in the dollar zone has broad implications:
- The chief obstacle preventing a sustainable improvement in US growth prospects has now been removed.
- Unlike the U.S., which has made substantial progress reducing excess debt and returning its banks to health, China has done all the wrong things, deepening the excesses on which its growth model is built.
- On a three to five year horizon, the US equity market could significantly outperform the Chinese equity market.
- The yuan’s inexorable rise against the US dollar may be over.
- The US is likely to see the end of cheap money.
- Renewed US competitiveness to cause “off-shored” business to return to the US.
- China to allow more capital inflows.
Michael Ashley Schulman, CFA