IMF Elevates Yuan to Elite Currency Status: So what?

© 2015 Prof. Farok J. Contractor, Rutgers University

November 30, 2015 was a red-letter day for China—and for Zhou Xiaochuan, governor of China’s central bank.

Governor of the People’s Bank of China (China’s central bank) since 2002 and a cautious and methodical bureaucrat, Zhou is the essence of his country’s Mandarin class: canny and understated, but relentless in his objective to elevate China’s economy and currency to elite status. Under Zhou’s watch, China’s exports to the rest of the world almost quintupled (see Figure 1), and in 2015 China is the world’s largest exporter, with 13 percent of the global total. If one takes the World Bank’s purchasing power parity (PPP) exchange rate, the size of the Chinese GDP in 2015 is neck-and-neck with that of the US. (See my January 2, 2015 post Is China set to become the world’s largest economy in 2015? This post was also published at Rutgers Business Insights.)

Figure 1: China’s Exports to the Rest of the World (2004–2014)

Source: Statista

And yet, few governments or institutions have been willing to hold the yuan (or renminbi yuan [RMB]) as an asset. RMB holdings comprise only around 1 or 2 percent of the rest of the world’s reserve total[1]. Nearly two-thirds of world government reserves (see Figure 2) are still held in US dollars—because of historical habit and because most international transactions continue to be denominated in dollars (gold, as a reserve asset, has a negligible part).

Figure 2: The US Dollar Still Dominates

Source: Michael Lingenheld. Forget the Military, America’s Greatest Weapon Is the Dollar. Forbes, March 13, 2015

What is a reserve currency and what functions does it perform?

Imagine that an Indian exporter has shipped goods to Malaysia and has been paid in US dollars. Being an Indian company, it turns over the earned dollars to a bank in India in exchange for rupees. The Indian bank, in turn, hands the dollars over to India’s central bank, again in exchange for rupees. The dollars end up being held by the Indian central bank, the Reserve Bank of India, as an official reserve asset.

Imagine then that an Indian importer wishes to import an item from China, payable in US dollars (assuming that most suppliers outside India are loath to accept rupees). The would-be importer goes to a bank with rupees and asks for dollars, which the bank supplies to the importer from the Indian central bank reserves.[2]

A country’s central bank reserve acts like a storage tank. As long as the dollar supply into the tank (from dollar earnings of exporters, remittances, foreign investment, etc.) is equal to or greater than the country’s demand for dollars from the tank (from importers or persons wishing to remit money abroad), the storage tank (reserve) will not go dry. The reserve acts like a buffer against fluctuations in imports and exports.

But a government’s reserve also can perform another function. If confidence in a country’s currency declines, and a sell-off of the currency occurs in the foreign exchange market, the currency’s exchange rate can devalue. Let’s say the Chinese government wishes to counter devaluationary forces and stabilize its currency. One method it can employ is simply to buy RMBs massively in the foreign exchange market. Increased demand for the RMB would prevent its devaluation and stabilize its value. But if the Chinese government buys RMBs in the foreign exchange market, it has to offer the seller something in return. What?

The answer is, for example, dollars from the Chinese government’s previously accumulated dollar reserves. This is exactly what occurred in mid-2015, when the RMB began to fall or devalue from 6.2 RMB/$ to 6.4 RMB/$. The Chinese government spent several hundred billion dollars out of its ($3–4 trillion dollar) reserves in order to stabilize the RMB and prevent it from falling further.

By the same token, if a government considers that its currency is getting “too strong” and wishes to devalue it, or prevent it from appreciating further, it could buy (demand) dollars in the foreign exchange market, offering the counterparties in the market its own currency. The extra supply of the country’s currency could prevent its further appreciation. The dollars the government buys end up increasing its official dollar reserves. (Also see my November 16, 2015 post Is China a “currency manipulator”? Donald Trump says so.)

What is the role of the IMF?

Until November 2015, the RMB comprised hardly 1 or 2 percent of other countries’ official reserves. Despite China’s position as the world’s biggest exporter, even Chinese imports and export orders are largely denominated in other currencies (such as dollars or euros). With the yuan being a controlled and not easily convertible currency, firms and governments outside China are reluctant to hold RMBs.

Zhou Xiaochuan and his government have been chafing and quietly lobbying to change that. Given China’s leading role in trade and in world economic rankings, to them it is humiliating to see the RMB have so tiny a holding outside China. If one counts both private as well as government (international, or non-local) assets, the dollar easily exceeds three-quarters of the value of non-local assets, compared with around 1–2 percent for the RMB.

The IMF is a mutual-assistance club of 188 country members. Its original principal purpose was, and remains, to help nations encountering a balance-of-payments crisis. Consider a hypothetical IMF member country in 2008—let’s call it Fredonia. Because of the global recession, between 2008 and 2012 Fredonia’s exports to the rest of the world fell sharply, and the dollars earned by Fredonia’s exporters fell by 30 percent. (This actually happened to many nations during the recession.) But Fredonia’s imports are essential items—energy, food, medicines, etc.—that could not be cut without hurting its population. And these commodities have to be paid for in dollars. (No one outside Fredonia is willing to accept “Fredos”— they insist that importers pay them in dollars).

So how does a nation like Fredonia continue to import vitally needed commodities if, on the export side, its exporters’ dollar earnings have fallen by 30 percent? It turns to the IMF (International Monetary Fund) for help.

The IMF helps nations facing a currency crisis to get dollar or other “hard currency” loans from other countries that have accumulated dollar reserves. The IMF thus acts as a friendly loan broker between nations and as a facilitator to tide over those countries suffering significant balance-of-payments deficits.

However, since 1970, the official government reserves of all 188 IMF members have grown much slower than world liquidity has. Put simply, growth in international transactions (trade or “imports + exports,” cross-border portfolio and direct investment, and private remittances) has been vastly greater than the growth of all countries’ national reserves. And recall our earlier discussion—that a country’s reserves are supposed to act like a buffer against shocks or shortfalls in foreign currency earnings. The typical nation’s buffer (or reserve) has not grown as fast as its international transaction volume, which can be a danger.

To alleviate this danger, the IMF created from scratch, or out of nothing (i.e., in its computers), a notional reserve currency called the SDR (Special Drawing Right), which it then divided and allocated to its member countries. The SDR is not a usable currency, and it does not exist anywhere except in the IMF’s computers and as a notional asset in member countries’ central bank computers. But it adds to each country’s buffer reserve and can be used in a balance-of-payments crisis.

In the example of Fredonia, during the period 2008–2012 when that country’s export (dollar) earnings fell way below its need for dollars to continue necessary imports, it could use the SDRs previously allocated to it by the IMF. Relinquishing its SDRs to the IMF, the IMF would then find another nation with surplus dollars in its reserves and ask that nation to temporarily (for a few years) swap SDRs for dollars with Fredonia. That way, Fredonia’s central bank would receive actual dollars that it could use to continue importing items critically necessary for its populace, augmenting the dollars earned by its exporters.

What’s the big deal about including the Chinese RMB in the SDR?

The SDR, a notional currency, is usable only in exchanges between central banks. Nevertheless, to effect the inter-governmental exchanges, the SDR has to have a formula to calculate its value. After 1999, with the introduction of the euro, the IMF decided that the euro would be allocated a 37.4 percent share or weight in the SDR, the dollar a 41.9 percent weight, the Japanese yen 9.4 percent, and the UK pound 11.3 percent—roughly reflecting these major countries’ role in global commerce at that time. But by 2015, China had muscled in and earned its status as a dominant player in international business, and the RMB or yuan could not be ignored, despite it puny role in international transactions and despite its being a not-easily-convertible currency.

After a debate of several years, and with steady pressure from Beijing, the IMF announced on November 30, 2015 that the yuan would be allocated a 10.92 percent share or weight in the formula for the SDR (see Figure 3). It is worth noting that the Chinese share comes at the expense of reduced shares for the euro, yen, and pound—but not at the expense of the US dollar, whose share and role in international business remains unchanged and paramount.

Figure 3: The Formula for the SDR

Source: Yomiuri Shimbun. IMF gives yuan reserve asset status. The Japan News, December 1, 2015

Is this a great victory for China—or mere symbolism?

Among the Chinese elites that run that nation, and among its increasingly assertive middle classes, nationalism and historical memories run deep. Five hundred years ago, China was the world’s biggest economy, and the humiliation of being overtaken and later suppressed by Japan and the West between 1895 and 1949 still rankles. Any recognition of China’s status in 2015 is appreciated and met with great pride by its people. Indeed, today it is the world’s biggest exporter and (on PPP exchange rate terms) an economy more or less the same size as that of the US. Yet, being allocated a 10.92 percent share in the SDR formula is at present a mostly symbolic triumph, since the SDR is not a real currency. However, it can lead to real changes over the coming decade.

Even with additional SDRs being “created” in IMF computers, the fact is that SDRs amount to a mere $285 billion and comprise only around 5 percent by value of all governments’ central reserves.[3] Moreover, all government reserves amount to a mere $6 trillion equivalent, which, in this author’s opinion, is a dangerously low amount given the huge liquidity in global commerce today. Liquid assets worldwide easily exceed $100 trillion, and daily turnover in foreign exchange markets worldwide exceeds $5 trillion. With only $6 trillion in total world reserves, the ability of governments to fight determined panics and capital flight is today dangerously inadequate. (See my September 10, 2015 YaleGlobal article Seeking Safety Abroad: The Hidden Story in China’s FDI Statistics).

It is therefore likely that the IMF will greatly increase its creation and allocation of SDR reserves to governments in the future. That, together with China’s eminent role, its assertiveness, and its continuing push to have other governments hold and trade RMBs, is very likely to expand the yuan’s role in the years ahead.

Even outside the IMF framework, China has been pushing bilateral swap deals worth 3 trillion yuan with more than 20 nations. For example, in 2013 the Chinese central bank swapped the equivalent of $30 billion worth of yuan for Brazilian real. This increased both countries’ official reserve position, but also provided encouragement to their importers and exporters to stop invoicing in dollars and use each other’s currencies instead. Trading in the RMB has significantly expanded since 2010 to seven offshore locations (see Figure 4), with transactions multiplying 23-fold by 2014 (albeit from a very small base).

Figure 4: Offshore Trading Centers for the Yuan

Original Source: Standard Chartered

Final Thoughts: Zhou’s story is China’s story

Zhou Xiaochuan – Photo Credit Vincent Yu/AP

Zhou Xiaochuan’s journey has been a remarkable one, from being ordered to work at a farm for four years during the cultural revolution (1968–1972), to being rehabilitated and earning a PhD in 1985 from Tsinghua University in Economic Systems Engineering, and to serving as central bank head for 13 years continuously under three presidential regimes—those of Jiang Zemin, Hu Jintao, and Xi Jinping.

Zhou’s story is also China’s story. A poor, developing nation in 1968 under the dictate of a centrally planned leadership, market forces—even partially unleashed under Deng Xiaoping—have wrought one of the most remarkable transformations in human history, whereby 800 million persons have had their lives lifted from a hardscrabble existence into a tolerable or comfortable middle-class life. And the number of billionaires in China now surpasses the number in the US.[4]

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[1] RMB internationalisation will benefit from stronger transatlantic, transpacific coordination. Standard Chartered Bank, June 22, 2015. 

[2] A bank in India would typically hold some of its own dollars for daily use, but the supply of dollars to an Indian bank comes from the Indian central bank, which in turn receives dollars from the export earnings of Indian firms, remittances, and other external sources.

[3] Factsheet: Special Drawing Right (SDRs). IMF, November 30, 2015. 

[4] See China now has more billionaires than U.S. CNN Money, October 15, 2015. However, according to Robert Frank, Countries with the most millionaires. CNBC Inside Wealth, October 13, 2015, the numbers of millionaires in the US—15.7 million—greatly outnumber those in China, at only 1.3 million (at least according to official data). That is to say, if you are a billionaire in China, it is difficult to conceal your wealth; but a mere millionaire in China can lie low, under the radar of official statistics.

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Is China a “currency manipulator”? Donald Trump says so

© 2015 Prof. Farok J. Contractor, Rutgers University

After 20 years, the Chinese government must be used to it—being bashed by US politicians and Congress as a “currency manipulator.” Indeed, the exchange value of the yuan (or renminbi [RMB]) is fixed each morning by its central bank, the People’s Bank of China (PBoC), with a narrow band of only + 2 percent allowed, up or down, within which market forces can have their say. In effect, it is an exchange rate set and controlled by the PBoC.

But why pick on just China?

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Most countries “manipulate” their exchange rates…

According to the IMF (International Monetary Fund), well over half its member countries’ governments meddle, in a mild or total fashion, to influence or fix their exchange rates. As shown in Figure 1, “Fixed Peg” and “Currency Board” are countries with currency values fixed for a considerable period of months or years. In “Managed Float” cases, market forces are allowed to play, but with the government intervening (buying or selling) to bias the exchange rate upward or downward. “Adjustable Pegs” are situations where the government fixes the rate temporarily—for months at a time or daily, as in the case of China. It is only with a few major currencies, such as the dollar or euro, that the government allows a “Free Float” with minimal or no intervention.

Figure 1: Percentages of IMF Member Nations Intervening in Foreign Exchange Rates (Source: IMF)

What exactly is behind the accusation of “currency manipulation”?

Generally, the accusation alleges that the government is keeping its currency too weak, overly devalued, or undervalued in order to give an artificial boost to exports while keeping out imports. This has the effect of boosting jobs in that country.

Take China as an example. A Chinese exporter earning a dollar turns it into the bank and gets 6.4 RMB yuan. By comparing costs in China and elsewhere, IMF and other economists calculate a hypothetical purchasing power parity (PPP) rate of 5.7 RMB/$, which would supposedly prevail under market equilibrium and without government meddling. At 6.4, some economists argue the RMB is still undervalued. But if the theoretical rate of 5.7 RMB/$ were to happen, the Chinese exporter would get only 5.7 RMB per dollar at the bank counter. The 6.4 RMB/$ rate provides a 12 percent higher revenue to the Chinese exporter, compared with the hypothetical 5.7 RMB/$ rate that some economists say should prevail. The still-undervalued 6.4 RMB/$ rate, they allege, gives the Chinese exporter an advantage.

By the same token, imports into China cost 12 percent more at the allegedly undervalued 6.4 RMB/$ rate than at the PPP 5.7 RMB/$. This, they allege, makes imports into China 12 percent more expensive than they should be, thereby keeping some foreign products out of China and benefiting (or protecting) Chinese firms that produce substitute products that compete with imports. On both the import and export side, an undervalued exchange rate boosts or preserves jobs in China (at the expense of jobs in the rest of the world).

But the Chinese have already massively appreciated their currency since 2005…

It must be particularly galling to the Chinese to hear accusations of currency manipulation since, succumbing to pressure from Western countries, they have already massively appreciated their currency in the 10 years since 2005. In June 2005, following more than a decade of a fixed exchange rate at 8.27 RMB/$ (when it was indeed undervalued), the Chinese gradually appreciated their currency all the way to 6.2 RMB/$ by July 2015. In the minds of many Chinese economists, their currency is no longer undervalued at around 6.2 for three reasons:

1. Between June 2005 and July 2015, the RMB appreciated/strengthened by 36 percent (see Figure 2)

This means that Chinese exporters in 2015 earned as much as 33 percent less that they would have at the 2005 exchange rate. Several Chinese exporters found themselves uncompetitive with the stronger currency and had to shut down their operations in China and relocate production to Vietnam, Bangladesh, or Africa.

Figure 2: China’s RMB Exchange Rate History (Source: Oanda.com)

By the same token, imports into China costing 33 percent less in 2015 than in 2005 means that some Chinese domestic production was displaced by imports.

In both cases, the appreciation of the yuan (RMB) has meant reduction of jobs in China, although this is consistent with the peaking of the Chinese labor force (partially as a consequence of the one-child policy). Indeed, several areas in China have labor shortages.

2. The yuan (RMB) has appreciated even more against other currencies

The PBoC fixes the RMB only against the US dollar. But in the last two years, this has meant that as the dollar has risen against most other currencies (such as the euro or emerging-country currencies such as the Brazilian real), the RMB has appreciated or strengthened even more, piggybacking on the dollar (see Figure 3).

Figure 3: The Yuan (Reluctantly) Piggybacking on the US Dollar
(Source: The Economist, May 30, 2015)

If one combines the RMB appreciation in Figure 2 (36 percent) with the dollar’s appreciation against most other currencies since 2013 (15 percent), the local currency cost of importing Chinese products may have risen by more than 50 percent since 2005 for many prospective buyers in a large swathe of nations from Europe to Brazil.

3. Chinese wages and costs have risen

On the east coast of China, where most of its manufacturing and economic activity takes place, wages have recently been rising at least 15 percent each year. Some jobs go unfilled. The one-child policy (reversed in 2015) has led to a plateauing of the labor force. Other costs, such as real estate, have also risen sharply. Chinese exporters are beginning to feel a squeeze between (i) rising costs and (ii) the falling RMB conversion value for the dollars or foreign currencies they earn.

So, why pick on China?

By massively appreciating their currency, the Chinese have succumbed to Western government pressure. While most economists aver that the yuan (RMB) is still undervalued, they agree that in 2015 it is not undervalued by much.

Indeed, if one were to search for a more egregious recent example, it would be the Japanese yen, which has been consciously devalued by the Shinzo Abe government by around a third since November 2012.

Figure 4: Yen per Dollar Exchange Rate November 2012–November 2015 (Source: Oanda.com)

One of the Abe government’s top priorities on taking office was to drive the yen downward (devalue it) from a historically high overvaluation of 80 yen/$ (at which rate few Japanese exporters could make any money) to a more devalued rate of 124 yen/$ (by 2015 when Japanese exporters could make profits). The math is simple. At 124 yen/$, each dollar earned by the Japanese exporter converted into 55 percent more yen, compared with the 80 yen/$ rate. In retrospect, it seems astonishing that so many Japanese governments prior to Abe’s allowed the yen to remain at an overvalued rate of 80–100 per dollar, which not only grossly dampened Japanese exports, but also put the economy into the doldrums for so many years. Most economists would agree that at around 115 yen/$, the yen would be appropriately valued—that 80 was too high and that perhaps the 124 yen/$ at end 2015 is a tad too low. At any rate, the Abe government’s actions have jump-started the Japanese export engine and restored a plethora of Japanese exporters to profitability.

But is this not also a case of currency manipulation by the Japanese? And, as noted above, the IMF reports that more than half of the world’s governments have a hand in influencing or adjusting their exchange rates.

So why then pick on only the Chinese, especially if, at 6.2 RMB/$ and with rising costs inside China, they are not too far from a realistic PPP rate in 2015?

Donald Trump, please read this post.

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Also see my May 8, 2014 post: Whither the Chinese yuan? Is the RMB still undervalued?

Chinese Cyber-Espionage on US Companies: The Asymmetry in the Analogy of the “Pot Calling the Kettle Black”

© 2015 Prof. Farok J. Contractor, Rutgers University

Chinese President Xi Jinping and US President Barack Obama. Joint news conference, Washington, DC, September 25, 2015.

PHOTO: PETE MAROVICH/BLOOMBERG NEWS (WALL STREET JOURNAL)

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American companies state that their secrets are being stolen by Chinese hackers. US counter-intelligence says it has traced several of these attacks back to outfits sponsored by the People’s Liberation Army (PLA),[1] and that designs stolen from American companies’ computers have shown up—sometimes barely disguised—in Chinese companies’ products and services. The Obama administration has threatened sanctions against hackers and Chinese firms that benefit from such intellectual property theft.

But wait a minute! Isn’t the “pot calling the kettle black”? The US has by far the best cyber-capability in the world and has used it to spy on millions of international communications, including Angela Merkel’s mobile phone—as well as to gather data from both European and Chinese companies’ computers. It can access any Internet-connected device, anywhere, to read its contents. So well-developed is the US government’s data-mining and cyber-capability that it has harvested detailed information, even family photos, on the very PLA hackers that penetrate American companies’ computers.

This is a “game” played by most major governments. So why single out China?

The “pot-and-kettle” analogy has a flaw: it is not symmetrical. The legal and political systems of the two nations tilt the game in China’s favor because:

• The Chinese government can, and does, share its information with its companies—especially State Owned Enterprises (SOEs)—whereas the US government cannot, for a myriad of legal and ethical reasons.

• SOEs, or government-controlled firms, still make up a major fraction of the Chinese economy, accounting for 34 percent of fixed total investment.[2] Some observers indicate that state ownership in China has continued to grow, not shrink, especially in key sectors (although the growth rate of private enterprise is even higher). The government-owned sector in the US, by comparison, is minuscule.

• As US firm CEOs made it clear to President Xi Jinping during his Seattle visit in September 2015, US companies in China are increasingly being squeezed and pressured to share technology and proprietary designs with Chinese partners as a precondition for doing business in China or getting access to markets. In brief, the Chinese government makes no bones about its drive to help its companies learn from US and European firms. Neither the US nor Europe makes any such demands on foreign investors.

The “pot calling the kettle black” notion does not, therefore, really hold up, even though the hacker abilities of US government or private experts are most likely superior to their counterparts in China. In the US, the role of government and its interests are separate from those of private business. The Chinese government sees its role as allied and interpenetrated with business, both SOEs and privately held companies. The Chinese have a very different notion of nationalism, and solidarity, that idealizes a utopian vision of all noses pointing in the same direction—one that promotes China. By contrast, the American War of Independence from Great Britain was fought largely on the very principle that government should keep its nose out of private business, and not tax or overly regulate commerce.

The farthest the US government goes in scrutinizing some incoming foreign direct investment (FDI) is through CFIUS (the Committee on Foreign Investment in the United States), chaired by the Treasury Secretary, that each year examines a handful of investment proposals that are sensitive in terms of defense or some vital strategic interest of the US.[3] In 2010, Tangshan Caofedian of China wished to acquire Emcore, a US fiberoptics and solar panel producer, but scrapped the deal because of objections from CFIUS.[4] In 2006, Dubai Ports World withdrew its agreement to take over the management of three US ports. Because of ideological embarrassment, the US government openly admits only to examining a handful of such sensitive cases each year, although CFIUS staffers, the Commerce Department, and the CIA probably cursorily and quietly screen thousands of FDI proposals behind the scenes. After all, the US is the world’s leading exponent of free markets and international business.

But the PLA-sponsored hacking poses a policy dilemma. What policy options does the US government have? Should the American government share commercial secrets it has gleaned from Chinese or European firms with US companies? Clearly, it cannot. Should the American government expand its scrutiny of incoming FDI, or even “encourage” foreign companies to share their technologies locally? That would be going against the principles and ideology of free markets, open entry, and separation between commerce and government. Should the American government sanction Chinese firms that have clandestinely appropriated American designs? That, too, is highly problematic since—in an interdependent world where US-China trade alone is worth half a trillion $US each year—sanctions would invite retaliation and a further squeeze on US companies invested in China. Retaliatory sanctions would further undermine the already fragile state of international business.

With the US and China alone making up approximately one-third of world’s gross domestic product (GDP),[5] a commercial war between the two could be ruinous to the entire planet—leaving no more pots and no more kettles to judge each other.

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[1] For example, see, among several similar news reports over the past three years, Cyber Sleuths Track Hacker to China’s Military. Wall Street Journal, September 23, 2015.

[2] Richard N. Cooper. China’s Growing Private Sector. Caixin Online, October 30, 2014.

[3] Jackson, J. The Committee on Foreign Investment in the United States (CFIUS). Congressional Research Service, March 6, 2014.

[4] Kirchgaessner, S. US Blocks China Fibre Optics Deal Over Security, Financial Times, June 30, 2010.

[5] Using purchasing power parity (PPP) estimates.

Capital Outflows from China and the Hidden Story in China’s FDI Statistics

© 2015 Prof. Farok J. Contractor, Rutgers University

Permission to Reproduce: A version of this post was published as  “The Chinese prefer investing overseas; dummy companies may ease transfers and devalue renminbi” by  YaleGlobal Online, September 10, 2015; it was the number-one story in a Google search for “China FDI” that day and is also available as a  podcast.

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The Sudden RMB Devaluation in August 2015

The global panic in financial markets in August 2015 was catalyzed by the relatively sudden devaluation of the Chinese yuan or renminbi (from 6.2 to 6.4 RMB/$). The Chinese government may have had several reasons for setting the daily reference rate for the RMB at a lower level, for example to signal greater market flexibility or to support its exporters. However, the fact is that enormous amounts of liquid money held by Chinese individuals and companies has—for many years—been anxiously trying to leave China (i.e., leave the RMB as an asset) and park itself in non-Chinese assets such as a Manhattan or Sydney condominium, US stocks, a Singapore bank account, or simply luxury goods. That has created the devaluationary pressure in the exchange markets.

Figure 1: RMB to Dollar Exchange Rate Changes – Summer 2015

Source: Yahoo Finance

The reasons are clear. China is getting richer, and by some accounts (using the World Bank’s implicit estimate for the purchasing power parity [PPP] theoretical exchange rate for the RMB[1]) it may already be coequal with the US as the world’s largest economy. In short, trillions of RMB in liquid assets are trapped inside China. Why trapped? Because the current rules do not allow the Chinese to convert RMB into other currencies without a commercial justification.

Capital Controls

A company or individual cannot just go to a bank in China with RMB and ask that they be converted into, say, US dollars. The request would be refused unless the form you fill out shows documentary proof that you are a sanctioned importer, or your child’s tuition in an American university needs to be paid, or that the Chinese firm has a foreign subsidiary that needs funds. In short: you need a provable justification.

Foreign Direct Investment (FDI) Outflows from China and the Difficult-to-Believe Statistics

One stratagem likely used by Chinese companies for getting permission to move funds out of China is to create dummy companies in Hong Kong and the Caribbean. As far back as 2011, the OECD (Organization of Economic Cooperation and Development) reported that as much as 57.4 percent of all outbound FDI capital went to Hong Kong affiliates or subsidiaries, and another 12.7 percent to Caribbean entities. (See Figure 1.) By contrast, Chinese companies’ outflow of FDI capital used to invest in European or US affiliates totaled a mere 8.2 percent.

Figure 2: Hidden Patterns in Chinese Companies’ Outward FDI

That means that as much as 70.1 percent of Chinese outbound FDI capital flows (exceeding $100 billion per year since 2011) has gone to two tiny economies, the Caribbean and Hong Kong. Moreover, data gleaned from UNCTAD (United Nations Conference on Trade and Development) shows a suspiciously large number of Chinese FDI-affiliated companies outside China. (See Figure 2.) For the world as a whole, the number of multinational companies (headquartered mainly in North America, Europe, and Japan) totaled 103,786. Of these, the UN data show 12,000—or 11.6 percent of all multinational firms in the world—as being headquartered in China. This appears plausible, as Chinese companies are indeed increasing their global reach. But then, in Figure 2, look at the number of foreign affiliates or subsidiaries of Chinese companies, said to total a remarkable 434,248 in number—or 48.7 percent of the world total.

If this is to be believed, Chinese multinational parent companies each had as many as 36 foreign subsidiaries or affiliates, as against the rest of the world whose multinational parent firms averaged only 5 foreign subsidiaries. Are the Chinese Ministry of Commerce numbers to be believed? Yes. With a 2,000-year-old bureaucracy, the Chinese usually do keep meticulous data. The numbers appear to be authentic, but they reveal a hidden story—that a significant fraction of the Chinese company subsidiaries in the Caribbean and Hong Kong are mere shell companies. Many of these dummy firms are likely created for a principal reason: to create a justification for the conversion of RMB into foreign currencies. In other words, the fake companies facilitate a hidden capital outflow that is not really intended for business purposes, but to get money out of China on behalf of the owners.

It is true that a fraction of the mainland China FDI outflow that goes to Hong Kong affiliates comes back to the mainland for investment purposes in a “round trip” (since a Hong Kong company can pose as a “foreign” investor and enjoy benefits such as cheap land that a purely domestic investor may not get). Other Hong Kong affiliates may be intended to mitigate the perceptual drawback of an investor originating from mainland China. But a significant (unknown) fraction of the outward FDI emanating from China and going to Hong Kong—plus most all of the outflows going to Caribbean havens—is intended for owners to get money out of China for tax benefits or to invest in a Singapore bank account, US equities, Australian property, or a Manhattan luxury apartment.

A World Awash in Cash and Liquidity (It’s Not Just the Chinese)

In 2015, Chinese purchasers topped the list of foreign buyers of Australian and US real estate. In the 12 months up to March 2015, the Financial Times reported that Chinese buyers spent $28.6 billion to buy US property and that Chinese are the top buyers of housing in New York, Vancouver, London, Sydney, and Auckland.[2] Hundreds of multimillion-dollar Manhattan apartments lie empty, functioning merely as an investment for wealthy foreign buyers that rarely visit.

But it is not just the Chinese who have become richer and seek to diversify their asset holdings out of China. The world as a whole is awash in liquidity (i.e., cash and quickly sellable assets), conservatively estimated upwards of $75 trillion and likely exceeding $100 trillion. Worldwide, mutual fund assets alone exceed $30 trillion,[3] with probably double that amount in bank or bank-like deposits.

In an important respect, this is a thrilling story. Probably a billion-and-a-half or two billion people around the world have become affluent enough to have investable savings. But then this worldwide flood of money is seeking places and financial instruments to invest in. And in a global arena, this creates the need to convert from one currency to another. When there is a sudden, collective rush to sell billions of one currency (and buy another), its value can go down sharply, despite government counter-purchases—as seen in the August 2015 devaluation of the RMB.[4]

Global Panics, Manias, and Exchange Rate Crises: A Thundering Herd of 500 Million Savers

Worldwide, a billion-and-a-half to two billion middle-class to affluent individuals—or, say, 500 million heads of households who actually manage the family’s savings—are aware of investment options and seek a place to park their savings. Likely, almost all of them have an Internet connection that amplifies news reports, fears, phobias, and panics. When all is said and done, in August 2015 no deep, fundamental economic reasons existed for the simultaneous swoon of stock markets around the world. The Chinese economy is slowing down, from the heady days of over 10 percent annual growth rate to a mere 6 or 7 percent. But so absurd is the news hype and consequent global angst, amplified by the Internet and media, that a 6 or 7 percent growth rate—which ordinarily would be the envy of most nations—instead gets protrayed as a reason to sell assets. Similarly absurd is the portrayal of a mere 3 percent devaluation of the RMB (from 6.2 to 6.4 per dollar) as cause for panic, selloffs, and crashes.

A global civilization that is intimately interconnected and awash in liquidity is also one that is prone to collective global psychology, manias, and herd instinct. Be prepared for more thundering hooves and market gyrations in the future.

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[1] The World Bank’s PPP exchange rate for the RMB is below 4.0 per US dollar, which, together with the 1.3 billion population, makes China’s economy large. See for example my January 2, 2015 post, Is China set to become the world’s largest economy in 2015?

[2] Anderlini, J., Chinese take lead among foreign buyers of US homes, June 18, 2015.

[3] 2014 Investment Company Fact Book, A Review of Trends and Activities in the U.S. Investment Company Industry (54th edition).

[4] Bloomberg News, China Sells U.S. Treasuries to Support Yuan, August 27, 2015,

Is China set to become the world’s largest economy in 2015?

© 2015 Prof. Farok J. Contractor, Rutgers University

China’s economy in 2015 may be as big as the US economy—
if you believe the World Bank’s economists

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The business press has been excitedly predicting the day when the Chinese economy will surpass that of the US in size. Just when this will happen has been a matter for debate—estimates have ranged from 2016 to 2025. 

In order to compare a nation’s economic size to that of other countries, economists first calculate the size of the country’s economy in the local currency and then convert it into a common currency (e.g., the US dollar). But the exchange rate used to convert from the local currency into the dollar equivalent makes all the difference. Conventional wisdom is that the Chinese yuan is still undervalued at the end-2014 official exchange rate of 6.2 RMB (renminbi yuan) per dollar. Using the official actual exchange rate, China’s economy (at $9.92 trillion in 2014) is still much smaller than that of the US, estimated at $16.92 trillion. See Table 1 below.

However, an alternative theoretical exchange rate—purchasing power parity (PPP)—exists that takes into account the cost of living in the nation. To calculate this theoretical PPP exchange rate is tricky business (see more discussion on this below). If we assume that people in the World Bank know their stuff, they estimate China’s PPP exchange rate at something around 3.7 RMB per dollar. Here are the World Bank’s numbers for GDP per capita, PPP (current international $, 2013); Population, total (2014); and Price level ratio of PPP conversion factor (GDP) to market exchange rate (2013–14):

Table 1

We also see from Table 1 that while the average per capita Chinese income is one-fifth compared to that of the average American’s, the population of China is more than four times as large. Hence the overall size of the economies appears roughly equal.

Extrapolate the 2013–14 figures by the difference between the annual growth rates for the US (approximately 3.5%) and China (approximately 7 %), and we get, for the start of 2015,

Table 2

Extrapolating at these growth rates further into 2015, we can estimate—based on PPP exchange rate calculations—that China will overtake the US by about mid-year.

Ambivalence and Caveats

The Chinese are ambivalent about this. On the one hand, they swell with nationalistic pride at such calculations: 

Source: Business Insider, October 8, 2014

On the other, the Chinese government has a vested interest in downplaying—even denying—this impending news. Whereas the government wishes to project China as a world power, it also finds it advantageous to portray the country as a poor emerging nation, still smarting from the wounds of colonial oppression, still needing to develop (indeed, the poorer provinces like Guizhou are hardly better off than Pakistan), still not needing to observe limits on carbon emissions. It is convenient, in world forums, for China to play the role of a peaceable nation that should still enjoy the privileges and indulgences granted to developing countries, and one that presents no irritants to its neighbors.

At the same time, China’s economists may be right in questioning the World Bank’s PPP exchange rate of around 3.7 RMB per dollar—this is a theoretical metric that exists only in the mind of an economist or accountant. In brief, the PPP exchange rate adjusts for the cost of living in each nation. Since the cost of living in China is much lower than in the US, the PPP exchange rate calculated by the World Bank (around 3.7 RMB per dollar) is much lower than the officially controlled exchange rate (of 6.2 RMB per dollar in December 2014). This is what is meant by the actual RMB exchange rate of 6.2 being “undervalued” in comparison with the theoretical PPP exchange rate of 3.7. However, the Chinese suggest that their currency is not really undervalued by much—at least in terms of trade competitiveness—since manufacturing wages and prices in Eastern China have been escalating at around 10 percent annually in recent years, rendering some manufacturing operations already uncompetitive if the RMB appreciates below 6.0 per dollar. (See my earlier blog post about the RMB exchange rate: Whither the Chinese Yuan? Is the RMB Still Undervalued?).

But when economists calculate the PPP exchange rate, they consider prices and cost of living not just in Eastern China, but for China as a whole. The cost of living in the middle and western provinces is much lower than in the eastern seaboard. For China as a whole, inflation has, according to official statistics, averaged only 3.6 percent over the 2004–2014 decade (see the World Bank Data—Inflation, consumer prices (annual %).

Conclusion

So the calculation of the PPP exchange rate for China—and therefore the estimate for the size of the Chinese economy—very much depends on what price data and geographic coverage the economist uses. At the World Bank’s all-China PPP exchange rate (around 3.7 RMB per dollar), China will have caught up with the US as early as this year (2015). At the end-2014 official actual exchange rate (6.2 RMB per dollar), it may take an additional decade or longer.