A couple of weeks ago, Daokai (David) Li argued that the “right” exchange rate for China isn’t clearly determined by China’s fundamentals. Or rather that two different exchange rates could prove to be consistent with China’s fundamentals.
“Currently, the yuan exchange rate regime yields multiple equilibrium. When we expect the yuan to depreciate, investors will exchange large amounts of yuan into dollars, causing massive capital outflow and further depreciation. If we expect the yuan to remain stable, cross-border capital flow and the exchange rate will be relatively stable. The subtlety that causes the equilibrium is that liquidity in China is the highest in the world. If there is any sign of change in exchange rate expectations, the huge liquidity in the yuan translates into pressure on cross-border capital flows.”
If China’s residents retain confidence in the currency and do not run into foreign assets, China’s ongoing trade surplus should support the currency at roughly its current level.
Conversely, if Chinese residents lose confidence in the yuan, outflows will overwhelm China’s reserves—unless China’s financial version of the great firewall (i.e. capital controls) can hold back the tide.
I took note of Dr. Li’s argument because it sounds similar to an argument that I have been making.*
I would argue that there aren’t just multiple possible exchange rate equilibria for China, there are also at least two different possible macroeconomic equilibria.
In the “strong” yuan equilibrium, outflows are kept at a level that China can support out of its current goods trade surplus (roughly 5 percent of GDP), which translates to a current account surplus of around 2.5 percent of GDP right now, though it seems likely to me that an inflated tourism deficit has artificially suppressed China’s current account surplus and the real surplus is a bit higher.**