On Currency Misalignments

This week's Economist discusses the problem of trying to tell whether or not an exchange rate is "misaligned" - that is, far from some sort of underlying equilibrium exchange rate. As the piece below describes, discerning this is not as easy as it sounds:

Misleading misalignments

“MISALIGNMENT” is all the rage. A new bill introduced into America's Senate proposes to punish countries where the exchange rate is found to be “fundamentally misaligned”... The bill, which is clearly aimed at China, follows a flurry of China-bashing proposals over the past year. But this one is different: it has widespread support and is likely to be passed before the end of this year.

Congress is hoping that it will be much easier to show that a currency is misaligned than manipulated. On June 13th, the day that this legislation was introduced, the Treasury decided yet again not to brand China a currency “manipulator” in its semi-annual report on exchange rates, but confidently declared that the yuan was “undervalued”. And on June 18th the IMF also announced a new framework for monitoring countries' exchange-rate policies. It will track indicators such as heavy foreign-exchange intervention and “fundamental exchange rate misalignment” in order to identify countries that are unfairly manipulating their currencies.

This activity is based on the widespread assumption that the Chinese yuan is hugely undervalued against the dollar. Yet the awkward truth is that it is almost impossible to be sure when a currency is misaligned, let alone by how much.

...There are three main ways of determining the “correct” value for a currency. The oldest is based on the theory of purchasing-power parity (PPP): the idea that, in the long run, exchange rates should equalise prices across countries (The Economist's Big Mac index is a crude version of this).

...A more popular definition of the fair value of a currency is the exchange rate that corresponds to a trade position considered “sustainable”. Thus China's large and rising current-account surplus is seen as hard evidence that the yuan is severely undervalued.

...Stephen Jen of Morgan Stanley prefers a third method of calculating the fair value of a currency: the so-called behavioural equilibrium exchange rate. This does not attempt to define long-term economic equilibrium. Instead it analyses which economic variables, such as productivity growth, net foreign assets and the terms of trade, seem to have determined an exchange rate in the past, and then uses the current values of those variables to estimate a currency's correct value.

Morgan Stanley uses no fewer than 13 models to value currencies... [According to these models,] the yen might be anything between 18% overvalued and 29% undervalued, depending on which model you trust. But nine of the 13 models signal undervaluation, with the median value suggesting the yen is 15% too cheap—the weakest currency in the chart. What about the yuan? Morgan Stanley uses only four models to estimate the yuan's fair value, of which the median valuation suggests it is only 1% undervalued against the dollar—not the answer Congress wants. Another surprise is that most other emerging Asian currencies now look overvalued.

None of these numbers should be taken as precise, but two conclusions follow. The first is that, in theory at least, there is a stronger case for declaring Japan's currency to be misaligned than China's. It is bizarre that the weakest currency is the yen, when Japan is the world's largest net creditor and had faster GDP growth than either America or the euro area in the first quarter. The problem, says Mr Jen, is that traditional models for estimating the fair value of currencies still focus mainly on the real economy, but increased cross-border investment flows (based partly on nominal interest-rate differentials) are now much more important. The second awkward conclusion is that the highly subjective nature of assessing currency misalignment will make it very hard for America or the IMF to agree on whether a currency is out of line.

The extent of any existing yuan misalignment is indeed open to question, and reasonable people (and models) can disagree substantially. That's why to me it makes more sense to think about whether government intervention in the currency markets are acting to depress or prop up the value of a currency. If the current market value of a currency is only possible with government purchases or sales of the currency, then that is prima facie evidence that the current market exchange rate is somehow different from its free-market equilibrium rate.

That is slightly different from saying that it is different from some sort of "fundamental" or "fair" exchange rate, because market participants may still bid the price of a currency away from that underlying rate, but it's a lot easier to conceptualize and measure.