China’s role in inflation in US won’t be transitory

Somehow, China’s currency doesn’t come up in conversation so much anymore. The mercantilist approach of the Trump administration has been abandoned, and the level of the yuan is no longer a geopolitical flashpoint. However, perhaps we should all pay more attention.
The yuan is now at its strongest in more than three years versus the US dollar. The last time it was at this level came in the summer of 2018, when Washington amped up its trade war rhetoric with extra tariffs, and China responded by allowing its currency to devalue, making its exports more competitive with US goods.
This can be taken as a sign that the intense economic conflict between the US and China is no longer being waged on the terrain of the currency and trade. But it’s even more interesting when we look at China’s real effective exchange rate, reflecting adjustments for different rates of inflation. If one country has higher inflation than the other, then its currency can weaken and leave the competitiveness of its exports constant. According to JPMorgan Chase & Co’s estimate of the yuan’s real effective exchange rate, based on consumer price inflation, the yuan is its least competitive since the summer of 2015. That was when China lurched into its closest approach to a financial and economic crisis since Deng Xiaoping took power in the late 1970s and began the great reversal from Mao Zedong’s policies. Six years ago, China botched its attempt to devalue the yuan after failing to prepare the ground, and global markets entered several months of severe stress before China opened the taps for more credit.
This is based on consumer price inflation, while China’s export trade is driven mostly by industrial goods and manufacturing, so it arguably fails to capture underlying Chinese competitiveness. If we instead look at a real rate based on comparing producer price inflation rates, we find a far more erratic pattern, but with the same ultimate result.
This makes it easier for the US to resist Chinese imports and to sell goods to China. But while that issue seemed to matter under Trump, the focus has now moved on to inflation. If Chinese stuff is more expensive, and Americans still want to buy a lot of it, that means inflation will go up. This is a potentially profound development. For a generation, China aroused American ire by effectively exporting deflation. Chinese workers would labor for far less than Americans, and so Chinese exports put a brake on price rises in the US, but also led to the hollowing out of much of the manufacturing-based working class. Now, just as the issue has turned to price rises, a stronger exchange rate would mean that China is effectively exporting inflation.
All this number-crunching reveals that China’s currency was indeed radically undervalued during the years of its mega-growth before the Global Financial Crisis. It has been overvalued, on the BNY Mellon methodology, for the best part of a decade, and has also been even more overvalued than the dollar. At present, both currencies are overvalued. Again, we can see that China reached very difficult territory in 2015, and that if the currency appreciates much more it could find life similarly hard. There are many reasons to expect the yuan to weaken; the ongoing crisis surrounding the property developer China Evergrande Group and the domestic real estate market means monetary easing of one kind or another is likely. Meanwhile, as amply discussed recently, it looks like the US will be tightening monetary policy, which all else equal should strengthen the dollar.

—Bloomberg