from Follow the Money

The problem with fair value calculations … JP Morgan, the dollar and China

September 19, 2006

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Drausio Giacomelli’s model for long-term effective real exchange rates indicates that the yen is undervalued by 9%, just a shade more than the dollar – which is undervalued by 8%.     The South African rand is also undervalued in his model, despite South Africa’s big current account deficit.

The Euro (and the Brazilian real) by contrast are overvalued … the euro by 8%, the real by even more. 

Does Dr. Giacomelli (JP Morgan uber-strategist) really believe the dollar is currently undervalued?  No.   He isn’t Stephen Jen.   He notes: 

“significant current account adjustments in the US have been associated with 10-15% under valuations, meaning a EUR/ USD in a 1.30-1.35 range”

He should have said significant adjustments in the trade deficit.   In the past, the trade deficit was basically the same as the current account deficit.  No more – the income balance is set to deteriorate significantly, so keeping the current account deficit constant means that the trade deficit has to fall. 

The problem with many of these kind of calculations (I don’t know if this applies to the JP Morgan model: I haven’t dug up the paper explaining its underlying structure and calculations of long-term real exchange rates can use different models that those models used to calculate "fair value") is that they assume that the average real exchange rate over say the last twenty or twenty-five years is close to the equilibrium exchange rate.    Yet the US trade deficit has steadily widened over the last twenty-five years.  It is unlikely that will continue for the next twenty-five years.    It is more likely that the trade deficit will fall over the next twenty-five years … and the dollar will fall along with it.

China realizes this. 

Fan Gang of the National Economic Research Institute (and China’s Monetary Policy Committee – he has taken Yu Yongding’s place) complains in an interesting policy paper: “The real question we should ask ... [is] why the US dollar has always got a tendency of devaluation against everyone else.” 

Fan is taking the long view, looking back to 1970s. On a shorter horizon, it isn’t really true.   The dollar rose significantly from 1995 to 2002.    

But looking ahead, Fan correctly realizes that the dollar is likely to slip further.    

Fan thinks the dollar’s international role pushes many of the costs of “loose” US policies on to the rest of the world: 

“… no matter how much the US runs on fiscal deficits, no matter how loose the monetary policies, no matter much the excessive liquidity provided, it [the US] has less likely run into financial crises like any one else in the world would do. ….  Meanwhile, being aware of not, other countries may face greater financial risks.  The huge stock of (over supplied) financial assets denominated in us dollars moves around knocking on the doors of developing countries.”

Right now, as Fan no doubt realizes, those dollars are finding a home in China.  Fan:

“The situation [Large US fiscal and current account deficits] is very challenging for the central banks of Japan, China, Korea, Taiwan and Singapore which collectively hold about US $2.8 trillion worth of US treasury bonds as part of their reserves.   The moment that they reduce their purchase, the value of the dollar slips.  Yet the more they buy, the more they are exposed to a potential free fall of the US dollar.”

Well said.  The question is what China should do about it.

Fan certainly has a few ideas.  But neither Fan nor Zhou  makes policy.   The State council does.

I think China hoped that if it demonstrated that if it showed its commitment to holding the pace of appreciation of the RMB below the RMB/ dollar interest rate differential, it could end hot money flows into China.   And it thought that if it ended hot money flows, it would end pressure for appreciation.   

Well, hot money flows did slow.   But the current account surplus grew faster than hot money flows fell.   The pace of China’s reserve accumulation did not slow.  I have a feeling that China’s August reserve growth was shockingly large.  The August trade surplus was close to $20b.  That is a lot of dollars knocking on the door …   

One thing that the Chinese policy makers might want to consider.  

The strong Euro hasn’t slowed Europe’s recent growth.    Europe did quite well over the past year.   There actually are ways of creating jobs other than subsidizing foreign direct investment by holding your currency down …

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