Yuan Real Exchange Rate Undervalued 5%-10%, IMF Report Says

China’s exchange rate is undervalued by 5 percent to 10 percent on an inflation-adjusted basis given the fundamentals of the country’s economy, International Monetary Fund staff said in a report released yesterday.

China’s “external position appears moderately stronger and the currency moderately undervalued compared with the level consistent with medium-term fundamentals and desirable policy settings,” the staff said in the report, which assessed the real effective exchange rates of 28 countries and the euro area. The report, dated June 20, said China’s foreign-exchange reserves are “somewhat above” a standard IMF measure and “further accumulation would be undesirable.”

The fund’s staff said in the report that the yuan appreciated by about 5 percent from the end of 2011 through April 2013 and “some 35 percent since the mid-2005 exchange-rate reform.” Before that, “the real effective exchange rate had been depreciating, so it is only 14 percent above the level reached a decade ago, which appears somewhat below the significant increases in China’s productivity relative to trading partners over the past 10 years.”

The yuan has fallen 0.04 percent against the dollar since the date of the report, according to China Foreign Exchange Trade System prices. The currency has risen 1.6 percent this year, the sole-gainer among Asia’s 11 most-traded currencies, according to data compiled by Bloomberg.

Yen Depreciation

“On China, where rebalancing has clearly taken place, it’s really a question of continuing the shift from domestic investment to domestic consumption,” IMF Managing Director Christine Lagarde told reporters in Washington yesterday. “We have seen it already in action for the last couple of years, but we need to see a continuation of that.”

Chinese exports fell for the first time in 17 months in June, while Commerce Minister Gao Hucheng said in a People’s Daily report today that the outlook for shipments is “not optimistic” in the second half. He added that China will keep the yuan exchange rate basically stable.

The world’s second-largest economy expanded 7.5 percent from a year ago in the second quarter, down from a 7.7 percent gain in the previous period. The IMF said on July 17 that risks are increasing that growth this year will fall short of its forecast of 7.75 percent.

Growth Quality

“There’s still some potential for the currency to appreciate rather than depreciate,” Jeremy Stretch, London-based head of currency strategy at Canadian Imperial Bank of Commerce, said in a Bloomberg Television interview in Hong Kong today. “We are not anticipating a hard landing. Even if we see a deceleration of activities, it’s the quality of the growth rather than the quantity of the growth that we need to be focusing on.”

The Washington-based IMF also said that relative to medium-term fundamentals, the depreciation of Japan’s currency since 2012 implies “moderate undervaluation, with estimates ranging from a 20 percent undervaluation to a 10 percent overvaluation.”

The yen “is expected to move in line with fundamentals over the medium-term assuming the implementation of comprehensive and credible fiscal and structural reforms,” the IMF said in the report.

A sustained 10 percent fall in the yen real effective exchange rate may cause growth in the rest of the world to slow by a “very small” amount of at most 0.03 percent annually, the IMF said in a separate report released today. Japanese Prime Minister Shinzo Abe’s push for monetary and fiscal reform would positively impact global growth over the long-term if implemented fully, it said.

China Slowdown

However, if the reforms are not executed successfully, global output could drop 0.5 percent after 5 years, the IMF said. If investors were to reconsider Japan’s sovereign risk, global output losses could reach 2 percent of gross domestic product, the IMF’s simulations showed.

In China, a sharp and prolonged growth slowdown will probably only happen after the next five years, given the significant policy space and resources still available, the IMF said. The impact of slower growth is expected to be around 1.5 percent of global GDP, the lender said.

China will avoid a collapse in investment as domestic consumption eventually lifts growth, the IMF found, basing its assumptions on fiscal and financial-sector reforms. In such a scenario, global GDP may be 1.5 percent higher after 10 years, and the exchange rate will be about 10 percent higher, it said.

The lender in the separate report also sought to gauge the impact that a normalization of the Fed’s monetary policy would have on the rest of the world. Depending on the strength of the U.S. economy and the reaction of long-term interest rates, the outcomes range from positive for all to costing several percentage points of growth to the U.S. and the global economy, according to the findings.

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