Implications of China’s Rise
“Some must get rich first, and help others to get rich in order to gradually achieve common prosperity ”
This article makes the case for increasing exposure to Chinese equities.
The “Penn Effect” is an observation that foreign exchange rates tend to vary relative to fundamental values (PPP) in predictable ways. Poorer countries often have undervalued exchange rates — i.e. they tend to have inexpensive Big Mac’s on the Economist’s famous hamburger index — and the inverse also holds for wealthier countries. The observation holds across countries and periods. It can also be predictive! As a country’s income converges toward the level of wealthier countries (e.g. the United States), that currency’s “discount” should begin to close.
Currency valuation vs PPP (x-axis); GDP per capita relative to USA (y-axis). Shown as log values.
Data from 1985 to 2020 (each dot is one year). Source: OECD and World Bank. GDP per capita is in real terms.
This has important ramifications if we apply it to China given the extent of undervaluation of the RMB (50% vs PPP). If even a minor income growth differential is maintained by China, the renminbi would see disproportionate (double digit) appreciation over time. Alternatively, if income growth rates of the US and China converged toward similar levels, but inflation differentials were maintained the RMB could still rise by a similar amount. That is because while the currency’s ‘discount’ to fair value may stay constant, that fundamental fair value (PPP-implied) would improve by a few % per year. It can also be a self-reinforcing cycle as an appreciating RMB reduces Chinese domestic prices (import costs fall).
This is not to say RMB appreciation will not go unchallenged in the near-term. The PBOC have stepped up warnings about “one way” bets of currency appreciation. In the past however, policy actions (e.g. reserve requirement adjustments on FX) have not had much sustained impact. Theories abound over recent FX drivers, but it could be that China is selling dollars received from record export surpluses (since FX deposits/reserves are stable) and this is weakening the greenback.
Asset valuations and forward return prospects are much healthier for China than in many other parts of the world. This is driving up capital inflows and will help reinforce support for the currency and capital markets in the face of more aggressive monetary tightening needed by the Federal Reserve.
Earnings yield is TTM earnings rolled forward by 1 year (using a LT EPS growth rate of 9.5%)