Although this makes me a bit dizzy, it is convenient if I start by quoting pgl quoting me (and Nouriel Roubini) at Angry Bear:
In the recent Roubini v. Altig debate... David replied:
In the overall scheme of things, if you put any faith at all in markets' ability to provide best guesses of such things, the expected magnitude of RMB-appreciation looks pretty moderate. By the last update I received, non-deliverable forward foreign exchange contracts were suggesting a total appreciation of about 8% over the next twelve months. That includes the 2% today. This is up a bit from yesterday, when 6% was the bet, but it still doesn't add up to great drama.
At this point pgl steps in:
David’s forward rate evidence suggests the market’s expectation of yuan appreciation is less than 10%. Suppose the market assigns a very small probability (say 10%) to the Chinese Central Bank letting the yuan appreciate significantly (say 40%) and a large probability (say 90%) to a modest revaluation (say less than 90%). David’s evidence would be consistent with the results [suggesting a large appreciation] derived from the Balassa-Samuelson relationship.
Well, all I can say is that is a really good point. The difficulty of gleaning the distribution of expectations from a simple forward or futures contract is exactly what motivates the use of options in calculating federal funds rate probabilities that I report each Monday.
That said, I'm not sure this example unambiguously cuts against the argument I was making. I might equally propose that pgl's figures are a variant of the "peso problem": An effect on an asset price that arises when there is a relatively small probability of an extreme event. What I was trying to say -- not as precisely as I should have, to be sure -- was not that I completely discount Nouriel's assertion that sizable RMB appreciations are possible, but that the market seems to be placing a larger probability on modest outcomes.
OK, that said let me second pgl's (and Brad Setser's) endorsement of Jeffrey Frankel's paper on this topic. It is clear, evenhanded, and flat-out one of the best analyses of the to-float-or-not-to-float debate that I've read. As pgl notes, Frankel employs a theoretical concept known as the Balassa-Samuelson effect to suggest that the Chinese currency is undervalued by nearly twice as much as Nouriel suggested. Here's a key passage from the paper:
Purchasing Power Parity (PPP) is often calculated as a guide for what the exchange rate should be, for China as for other countries. But the overwhelming majority are estimates of relative PPP, that is, based on price indices. They do not necessarily show the yuan to be strongly undervalued. But that may be because they use the past as the benchmark, and the yuan may have been undervalued in the past.
Comparisons of price levels across countries are difficult, because such absolute PPP data are much less available than relative PPP data (for which one only needs price indices and exchange rates). But some data are available. As of 1990, China’s price level was reported as only .119 of the US price level, according to the Penn World Tables, Mark 5.6.
I have no complaint about those comments at all, but this warning from the people who construct the Penn World Tables is important:
The wide range of PPP estimates for China and the large size of their difference from the exchange rate suggest that substantial uncertainty is associated with these numbers... the basis for purchasing power estimates for China is very little improved over previous versions of PWT. Further, the need to look seriously at the current and
constant price estimates of China remains.
Note that these comments pertain to a newer vintage of the Penn World Tables than the version Frankel references, and he repeats the warning himself:
Few economists would seriously recommend a revaluation over a short period of time of the yuan on the order of magnitude suggested by this interpretation of the Balassa-Samuelson equation. In the first place, a sudden revaluation of the currency of this magnitude would be disruptive. In the second place, other considerations matter in addition to the Balassa-Samuelson regression, including current monetary conditions. In the third place, one would first have to investigate the reliability of the Chinese price data. It is possible that the numbers in the Penn World Table have been extrapolated extensively from a slender base.
When it comes right down to it, all I have really been saying is this: For all practical purposes, China is still a black box. I don't have a lot of confidence in events playing out in the relatively benign fashion I envision, but that doesn't imply any greater confidence in more sinister scenarios.
Foornote: If you are new to the idea of Purchasing Power Parity, here is the link to the Wikipedia entry.