Renminbi, ruble poised to climb

by Levi Folk | May 27, 2008

Emerging markets have kept growing in the face of a slowing U. S. economy. Inflation is a major concern for the emerging markets over the near term, and in many circumstances currency appreciation is a likely outcome.

The current round of inflation is being caused by surging food and commodity prices, and it appears food and energy price inflation will remain a problem for the developing world. The reasons are simple: strong economic growth and rising incomes in many emerging markets are increasing demand relative to supply. Moreover, oil price inflation combined with global energy policies are creating food price inflation.

Higher oil prices raise the cost of food production, which eventually feeds through to higher prices. Nestle, the world’s largest food and beverage company, has maintained margins and profit growth despite rising commodity costs by simply raising prices.

As well, U. S. energy policy aimed at reducing oil imports (which appears to be working) places heavy emphasis on ethanol production. Roughly one-quarter of U. S. corn production has been diverted to ethanol production, more than the amount of corn that will be exported from the United States in 2008.

Rising corn prices are leading farmers to divert crop production to corn, which in turn is increasing the cost of pork, for example.

Monetary policy in many emerging markets has been accommodative of this inflation, but this will likely have to change. This is not a minor policy change for many countries that have been managing their exchange rates by pegging to the U. S. dollar. The upshot is that currencies will need to appreciate in many emerging economies over the near term, and this presents an opportunity for investors.

The value of a currency can rise in either one of two ways: inflation or nominal exchange-rate appreciation.

Rapid inflation in emerging markets, for example, causes a real exchange-rate appreciation that, if left unchecked, will create competitive issues for that country and could lead to a vicious cycle of inflation and exchange-rate depreciation for competitiveness reasons. It is obvious that emerging market economies that have been growing strongly will want to avoid this possible outcome.

Which countries are most likely to experience currency appreciation over the next few years? Those countries with strong economic growth, large current account balances (a surplus means dollars are being earned by the country for trade, services, etc.), increasing inflation, managed exchange rates and large levels of foreign exchange reserves are the most likely candidates for appreciation.

China is at the top of this list.

Economists have been claiming that China’s currency, the renminbi, is undervalued and have been calling for authorities to allow it to appreciate versus the dollar.

Until recently, authorities in China have resisted currency appreciation because a large and growing trade surplus with the United States has been desirable to China’s policy makers who have been pursuing a growth-at-all-costs policy. China’s current account deficit is estimated at 9.8% of GDP for 2008 by the IMF.

In fact, the People’s Bank of China (PBoC) has bought U. S. dollars in recent years to keep its currency from appreciating to maintain export competitiveness and to finance the U. S. trade deficit. Official foreign exchange reserves currently sit at roughly US$1.3-trillion and they have been lent back to the United States through official Treasury holdings.

The problem with reserve expansion is that it is inflationary because it creates expansionary money supply. Now that it has to contend with rising food and commodity inflation, the past PBoC exchange rate policy is untenable.

Since the start of the year, renminbi appreciation has accelerated, rising at a 25% annual rate in the first quarter. Over the next year, inflation pressures could easily force the renminbi higher.

Higher commodity prices are a major factor but, unlike China, they actually benefit Russia, a major commodity producer. The country operates with a substantial current account surplus worth roughly 5.8% of GDP for 2008 according to the IMF.

Russia is the largest producer of both oil and gas and has claims to the largest supply of gas reserves in the world. Energy revenues helped Russia’s economy expand 8.1% in 2007.

The ruble has appreciated strongly over the past few years, but there is good reason for the ruble to rise this year and in 2009: The Bank of Russia may be forced to allow it to rise to stem inflation.

In countries like China, higher commodity prices will likely result in slightly slower growth and higher currency appreciation. In a commodity producer such as Russia, higher commodity prices are inflationary and suggestive of currency appreciation that with little consequences for long term growth.