16.11.2011 Ernst Grönblom


Banks – Fundamentally Unstable
FAQ: HCP Asset Management

Renminbi (traditional characters: 人民幣, simplified characters: 人民币, pinyin: rénmínbì. Literally people’s money) is the official currency of China, controlled by the People’s Bank of China. The currency’s primary unit is yuan (元), which is formally 圆, to make counterfeiting difficult. 1 yuan = 10 jiao (角) = 100 fen (分). The largest renminbi note is 100 yuans and the smallest coin is 1 fen (source: Wikipedia).

Value of currency

There are several different methods to value a currency. To laypeople the most familiar one might be the official exchange rate, which is the price a tourist pays when exchanging currencies before a trip abroad. When writing this (17.11.2011) the official euro / renminbi rate is 8.55, meaning that one euro gets you 8.55 renminbis.

The value of a currency can also be evaluated by its purchasing power, which estimates the amount of currency needed to have equal purchasing power compared to some other currency.

For example: if we evaluate purchasing power by purchasing a car – let’s say a Toyota Yaris – purchasing power parity is calculated as following:

The price of Toyota Yaris in Finland: 20,000 euros

The price of Toyota Yaris in China: 60,000 renminbi

Purchasing power parity calculated using the previous prices = 60,000 / 20,000 = 3 (indicating that one euro is worth 3 renminbis)

But wait a second; the official exchange rate is over 8 renminbis! Where does the difference come from? One way to explain the difference between the official exchange rate and the purchasing power parity is to say that renminbi is – based on the value of Toyota Yaris cars – approximately 60% ((3-8)/8 * 100 = 63%) undervalued compared to the euro.

Measured by purchasing power parity, renminbi is currently notably undervalued compared to the euro. Although all purchasing power parity calculations are rough estimates, different statistics (for example the Economist magazine’s “Big Mac – Index) show that renminbi was undervalued by 70 – 30%, depending on the comparison method in July 2011. The value of renminbi should appreciate against the euro in order for the currencies to be equally valued when measured by purchasing power parity.

Source: THE Economist’s Big Mac index is a fun guide to whether currencies are at their “correct” level.

Why are we discussing purchasing power parity? Because the common understanding is that differences in the purchasing power parities converge over time.

This is because of the law of one price, which is widely accepted in economics. The law states that in efficient markets, identical products can have only one price.

Basically this means that if trading is not restricted in any way, sellers will go wherever they can get the highest price and vice versa, buyers will go where they can get the lowest price. The situation, in which a profit can be made without risk, is called arbitrage. According to the law of supply and demand bargaining continues until supply and demand meet and the market reaches equilibrium (and at the same time a price – the only price)

Economics find a market to be efficient if it is arbitrage free, meaning there aren’t any long-term arbitrage situations in the market. If an arbitrage situation appears, people will start exploiting it and the arbitrage disappears: taking advantage of an arbitrage increases demand in the markets where prices are lower, which leads to higher prices. On the opposite side, more products will be available in the markets at a higher price, increasing supply and forcing the price to go down. The price of the product increases where it was cheaper and decreases where it was higher until the prices are the same and arbitrage doesn’t exist anymore.

For example, if one could buy gold for 500 euros per ounce in China while the price in Europe was 1,000 euros per ounce, it wouldn’t take long for investors to start buying gold from China and selling it in Europe. The increased demand in China would drive the price of gold in China higher; while the increased supply of gold in Europe would drive the price of European gold down. The process would continue until the price of gold would be the same in China and Europe, or the price difference would be so small that arbitrage wouldn’t be profitable. Arbitrage opportunities also depend on the commodity; the more generic and movable the commodity is, the faster and more efficient the arbitrage process is. Some products and services are local and their prices are determined by the local conditions. For example real estates are especially tied to their geography; even though Peking would have an oversupply of available apartments, it doesn’t help a person looking for an apartment in Helsinki, who is struggling with the lack of supply and high prices.

How does this influence the Chinese currency? In case the hypothesis of the undervaluation of renminbi is true, the market forces should push the value of renminbi up. So far China has artificially kept the value of renminbi down (China has been criticized for this policy). This policy has been favorable to Chinese exporting industry, by making Chinese products appear cheap to foreign countries, which increases Chinese competitiveness.

We can identify at least the following trends that will push the value of renminbi up.

(a) Globalization and the more open global trade. Why? Because the increasing global trade creates more efficient markets than ever, which strengthens the law of one price.

(b) The economic growth of China (I). Why? Because a country’s currency reflects the country’s economic conditions; when economy improves the country’s currency often appreciates and vice versa. The “natural” value of renminbi will keep increasing along with the economic growth of China. (Some economists have warned that oversized investments have fueled the growth of the Chinese economy and created a bubbly, similar to the staggering growth in the former Soviet Union, which eventually collapsed. Chinese growth is not only fueled by foreign direct investments, but also by improved productivity, which differs from the Soviet Union’s case and should make the growth sustainable.

(c) The economic growth of China (II). Why? Because when the economy grows, the pressure to fix discrepancies (such as unnaturally cheap currency) increases. A correction is more likely to happen.

(d) The increasing political pressure combined with China’s attempt to increase its political power. Why? Because China’s attempt to be viewed as a true superpower, forces it to start operating less fraudulently. It is possible that China will not be treated in the international arenas the way it would want to, until China starts to play by the rules. The rules include for example respecting intellectual property and free-floating (un-manipulated) currency. Right now, EU and USA are being tough against China because of its “unnaturally” cheap currency.

(e) The transition from export emphasized economy to domestic expenditure. Why? Because when a country’s economy improves, the focus from exports shifts to domestic markets. When Chinese have reached a certain level of living standards, they will start demanding western product at right prices (purchasing power parity).

(f) The general democratization process. Why? Because the current “cheap renminbi policy” has mainly favored the heavy industry owned by the state. Assuming that China continues its democratization process, eventually the economy will democratize as well. This will make it more difficult to favor exports on the expense of other industries.

As we have indicated above, we can say that the pressure for renminbi to appreciate is high and increasing. If the global economy doesn’t face any significant changes (for example a noteworthy weakening of the Chinese economy), it is highly likely that the value of renminbi (both the official exchange rate and the purchasing power parity value) will increase eventually.

When pondering about the future development of the value of renminbi, classic words (although initially said a little jokingly) from a famous economist Herbert Stein shall be kept in mind: “If something cannot go on forever, it will stop.” China cannot keep the value of renminbi artificially low forever.

It can be concluded that measuring by purchasing power, renminbi is currently cheap (or inversely, euro is expensive) and therefore one euro buys currently too man renminbis. Relying on common sense, one should buy when things are cheap and sell when expensive. Relying on common sense one should buy renminbi (especially by selling euros).

Before we all run to bet the ranch on the appreciation of renminbi, a few wise phrases should be kept in mind.

According to Ahti Karjalainen: “Predicting is difficult, especially predicting the future.” Although there are several good reasons to believe the value of renminbi will go up, it doesn’t mean it will happen. We can only make predictions of the probabilities of future outcomes. Even though we think that the value of renminbi will most likely increase in the long run, it is not certain.

Secondly, “long run” can mean a really long period of time. We have previously stated that the renminbi is undervalued looking at it´s fundamentals and wee see that  it´s value should increase in the long run. Situations can change and even if we are right, it can mean we are right  several years, or decades before we see any correction. Keynes said: “The market can stay irrational longer than you can stay solvent.”

As a conclusion we can say that renminbi based investments add diversification to a traditional portfolio with notable upside potential and relatively low risk. We think an asset manager’s job is to continually find something new and better.

Banks – Fundamentally Unstable
FAQ: HCP Asset Management
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