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OPINION

What drives China's currency

What drives China's currency
December 6, 2012
What drives China's currency

Only if I reckon it implies further weakness in the currency. To assess that we need to think about the factors that will drive demand for the renminbi. As for any currency, they can be shepherded under two headings: the demand prompted by cross-border trade and the demand driven by inward investment. There is, incidentally, a third generic factor that, as yet, does not really apply to China's currency - the influence of speculators (much like Bearbull) who try to anticipate both the demand for a currency and the central bank's response to it.

On all measures, China's trade surplus is not what it was. True, the country remains the world's biggest manufacturer (marginally pipping the US), but - in 2012 at any rate - it's no longer the leading exporter. Currently, Germany is ahead with an annualised current account surplus running just above $200bn, while China's is just below. Low value-added China has suffered more than high value-added Germany, as the anticipated recovery in the developed world's demand for the bits and bobs of consumer spending has not met expectations.

Other factors have conspired against China. Its 'terms of trade' have deteriorated. That's another way of saying that the cost of its imports - especially oil - has risen faster than the price of its exports. Taken together, this means China is likely to run out with a 2012 current account surplus slightly shy of 2.8 per cent of national income (GDP), the figure that the International Monetary Fund (IMF) forecast at the start of the year. This would be the lowest proportion since 2001 and will contrast sharply with a surplus of 10.1 per cent of GDP in 2007.

So China no longer looks like the exporting juggernaut that Mitt Romney boasted he would label a 'currency manipulator' in his first day in the White House. Indeed, the IMF reckons that, given various economic parameters, China should be running a trade surplus of 2.9 per cent of GDP, pretty much where it is.

As to inward investment into China, there isn't much. That's because China can satisfy its gargantuan appetite for capital from its own resources. Give or take, about half of China's $6,000bn of national income is saved rather than spent. By the standards of the developed world, such a savings ratio is astonishingly high. It could also indicate that the currency is badly undervalued. That's because the savings ratio implies that consumers only save so much because the imported goods they'd like to buy are out of their reach. And the goods are so pricey because the government keeps the currency so low in order to provide plentiful cheap capital for investment.

Quite possibly. Two things are clear, however. The first is that China's level of capital spending is extremely high - it also runs at around 50 per cent of GDP. Second, compared with the developed world, China's stock of capital equipment per worker remains small. The figures are vague, but quite likely the average Chinese worker is backed by just a fifth of the capital equipment that underpins the efforts of the average US worker, which largely explains why the US's manufacturing output is bigger than China's, despite its relatively small manufacturing workforce. Put these two together and we have a situation where China's pace of capital investment is both too high - how can any country spend so much on capital projects and not waste a lot? - and is fully justified.

But this has implications for the renminbi exchange rate. It suggests further instances of the scenario by which China became the world's largest exporter of steel. That followed massive investment in a steelmaking plant in the early 2000s. At first, new production replaced steel imports, it fed rising domestic demand, but before long it went into the export market. In other words, some of the extra production from this vast amount of capital spending will be channelled into export markets, boosting China's trade surplus and putting further upwards pressure on the renminbi.

It's pressure that China's government will find increasingly hard to counter and, ultimately, may be loathe to resist. Hard to counter because keeping a currency artificially low entails various distortions, the most harmful of which are high inflation and low interest rates. Loathe to resist because at some stage China must allow the driving forces of its economy to shift. There will be less emphasis on exports and capital spending and more on consumer spending and the construction of a welfare state. All of which suggests that a little short-term weakness in the renminbi should not worry anyone backing it for the long haul.

Bearbull Global Portfolio
HoldingCodeWeight (%)Price dealtPrice now% changeValue
iShares Emerging Mkts SmallCapSEMS233,9023,927123.4
iShares MSCI WorldSWDA161,8101,902516.4
iShares MSCI Emerging Mkts SEMA111,9861,793-109.7
ETFX Global Agri BusinessAGRI1232.9933.19112.4
ETFS Brent 1 monthOLBP83,2514,1152710.2
ETFS CocoaCOCO92.501.91-247.0
ETFS Norwegian kroneGBNO65,1045,23536.5
ETFS Chinese renminbiLCNP1532.9131.95-314.9
Fund's starting value (Jan 1, 2011)100Value now100.5
FTSE Global All-Cap (rebased)100100.3
*As at 30 November 2012