How relevant is Current Account Balance?

The general perception to how relevant is Current Account (CA) balance is "very relevant", when it comes to exchange rate. Professional economists and politicians alike (and those whose status is somewhat in between) point to China's stunning CA surplus as a convincing evidence that China's RMB is significantly undervalued. While it is for us to judge how convincing each piece of evidence is, the consensus seems to suggest that it is beyond reasonable doubt. This view is so popular that when I questioned the validity of this view on facebook, during casual conversations, or on other occasions, hardly anyone would take it seriously.

Unfortunately, consensus hardly mean convincing. Before the current financial crisis, there was a consensus of "Great Moderation", an optimism that assures us that financial crisis is in history, at least for developed nations, like US, which is soon to be shattered by the hard reality. This view, in the case of China, is equally problematic.

What is Current Account? Current Account is the sum of Balance of Payments (BoP) and capital account. Capital account usually is left out of consideration and the game is on BoP. BoP is defined to be earnings on exports minus payments for imports, and it is intuitive that is captures the trade position of an economy. However, to appreciate what BoP does not capture, let us consider a simple example. There is a country B(ritian) which set up a colony A(merica). I will tell the story where gold is the only currency. B sends some people to A, to extract the natural resources in A. Since A is so resourceful, every year trillions of tons of gold worth of natural resources are exported from A to B, resulting in a huge deficit for B. In other words, BoP for B is stunning. Surprisingly, governors of B are not worried at all, because they know that after ten years, all people in A will return, and A will return to uninhabited (or disappear). This story, while artificial does point to one weakness of BoP--years of BoP surplus (or deficit) can suddenly be reversed by capital account, a normally out-of-picture channel, via emigration.


How relevant is this example for Sino-US exchange rate debate? More relevant than CA at least. The Economist calls attention to facts listed in the latest edition of "Hurun Report":

Mainland China can now boast over 1m wealthy citizens (qianwan fuweng) each with over 10 m yuan ($1.6 m), says the latest edition of the "Hurun Report"...more than 16% of China's rish have already emigrated, or handed in immigration papers for another country, while 44% intend to do so soon. Over 85% are planning to send their children abroad for their education, and one-third own assets overseas.

 To put this in perspective, China boasts of about 3 trillion USD in foreign reserves, while "the richest 1% of Chinese households own $2 trillion-5 trillion of property and liquid assets" according to Victor Shih of Northwestern University. The emigration wave, not just confined to the richest 1%, could easily deplete China's foreign reserve, which will then force China to depreciate its currency, an event unthinkable for many.

The above discussion points to one aspect of CA that is often over-looked. Unfortunately, (perhaps fortunately for aspiring researchers), inferring currency overvaluation/undervaluation from BoP or CA is generally problematic. Micheal Spence, a Nobel laureate in economics,  pointed on one apparent difficulty:

But, in order to explain performance relative to Japan and Germany, one would have to argue that the euro and the yen have been undervalued, which makes no sense.

As for the case of China, there are even more reasons to be cautious before subscribing to the majority view. Given a general expectation that RMB will appreciate (partly fueled by the dirty politics), many investors, hoping to reap the benefit from the appreciation, disguised their hot money as trade flows to avoid the capital control imposed by China. With this, when we look at the BoP, the prospect of an appreciation seems more rosy--after all, the exports are so huge compared to imports, while a potentially big chunk (nobody knows how much) of the difference is explained by the disguised hot money. This might in turn, fuel unrealistic expectation, which in the short turn pushes RMB to appreciate. Another danger is the weak or defunct banking sector. Hot money is notoriously myopic--considerable amount flowed into Korea, Thailand, Indonesia and other Asian economies when the banking sector in those economies were already extremely problematic, and only reversed themselves (suddenly) when the crisis breaks out, creating one of the traumatic experience for those Asian economies. Even with the absence of emigration concern, the failure of Chinese banking sector, might trigger a large capital reversal, which would deplete the seemingly inexhaustible foreign reserve of China. An exchange rate collapse, is all but unthinkable.

While I would not short RMB--the market can stay irrational longer than I can stay solvent; but at least, I would not contribute to the hot money. I am actively converting my RMB assets into USD-denominated, though I do not intent to emigrate any time soon.

Reference:
1. Spence, Micheal. "The Exchange-Rate Delusion." Project Syndicate. N.p., 19 Dec. 2011. Web. 09 Aug. 2012. <http://www.project-syndicate.org/commentary/the-exchange-rate-delusion>.

This is a wonderfully and brilliantly piece written by one of my favorite economist--Micheal Spence.

2. "BoP until You Drop; the Balance of Payments." The Economist (US) 4 Aug. 2012: 40. Print.