China might be revaluating its currency

09Apr10

The New York Times has ran two pieces in the past two days relating to China and its currency. The first is that Timothy Geithner met with the Chinese vice prime minister, Wang Qishan, yesterday. Like so many diplomatic meetings, especially those involving China, both parties probably tried their hardest not to say anything of any real importance, so as not to cause any upsets, but it also points out that Geithner probably continued to nudge China to allow their currency to increase in value against the dollar. There are signs that may actually happen too: yesterday’s article mentioned a series of signs that China might allow the renminbi (or yuan, if you’re into that sorta’ thing) to appreciate.

Now, what exactly does this mean, and why is China doing it?

The thing to understand about exchange rates is that, most of the time, they are not set by some government authority or shadowy cartel of bankers, but simply by supply-and-demand, just like any other commodity. If the United States economy is doing well, investors all over the world want to put their money into American investments, and since they need dollars to do that, they have to exchange their local currency for dollars. Hence, demand for dollars increases relative to supply, and so the price of a dollar relative to other currencies (its exchange rate) strengthens. Likewise, if investors feel there are better opportunities elsewhere, they use their dollars to purchase other currencies, and the value decreases. Governments can take some action with regards to the value of their currency (last year, for example, Russia spent a great deal of its oil-money to prop up the value of the ruble, an effort that largely succeeded but cost Moscow a huge portion of its budget surplus), but not as much as much as they would probably like, and at any rate, the WTO looks askance at “currency manipulation” – unfair government interference on the value of a nation’s currency to gain an unfair trade advantage.

Many smaller economies, however, prefer to “peg” their currency to a larger one, usually the dollar or the Euro. There are a couple reasons for this: most notably that they prefer their currency to be shielded from moderate fluctuations in the market, which would have little effect on larger economies but could cause the value of their own currency to fluctuate wildly, which is obviously undesirable. China did this up until 2005, pegging their exchange rate at 8.27 yuan per dollar. Because of both pressure from foreign governments and the desire to make China a real player in the global currency market, China lifted the peg in 2005 and now values the yuan against a basket of currencies, but they have still endured a great deal of criticism that the yuan is being kept artificially weak.

Even if there’s no currency peg, there are a couple ways they could do this. One Chinese policy that is often cited as an artificial currency manipulation tool is their “purchase quota”: both Chinese and non-Chinese citizens can only change a total of $50,000 worth of yuan per year, in either direction. No one can sell more than $10,000 worth of yuan in a single day, or buy more than $500 worth (some exceptions are made for large corporations, obviously, since they have to deal with much greater currency amounts on a daily basis, but even these are viewed as needlessly strict). The criticism is that because these quotas impose hard limits on the number of yuan that can be bought and sold, they don’t allow its value to fluctuate with supply-and-demand.

This bugs other countries for a couple reasons: with a weak yuan, one dollar is able to buy many yuan, making Chinese imports cost less. The weaker the yuan, the less Chinese companies need to charge for their products, since it takes fewer dollars to net them the same amount of revenue. Likewise, foreign companies find it harder to do business in China, since Chinese customers have to spend more yuan to get the equivalent amount of dollars necessary to buy the product. There are complaints that China is performing this currency manipulation in order to give its industry and unfair advantage over those of other countries, both in China and elsewhere. Not only that, but it makes it more expensive for people to invest in China, which some people are saying is intended to unfairly limit control of Chinese companies to Chinese nationals.

However, currency manipulation is not the only explanation for these actions, there are some legitimate ones too, such as trying to prevent the yuan from getting too heavily involved in the “carry trade”. A carry trade is when people borrow money in one country, for the exclusive purpose of exchanging it for other currencies to borrow money in another country. Currencies with low interest rates and/or little economic growth are popular for carry trades. The thing about carry trades is that they are a double-edged sword: they can be very helpful for a country in some situations, and very damaging in others.

I’m going to use Japan as an example, because the yen is by far the most heavily carry-traded currency today. Ever since Japan’s recession in the 1990’s, the BOJ has set the interest rate of the yen extremely low (often zero), meaning for years it has been very cheap to borrow Japanese currency. Investors have taken advantage of this by borrowing tons of yen, converting it to other currencies, and then using that money to make investments in other countries, at less cost then it would take than to borrow the money in that currency directly. This has the net effect of weakening the yen against other countries (since everyone is trying to buy other currencies with their yen), which is a good thing for a highly export-driven country like Japan: the weaker the yen, the more yen foreign customers can buy with their money, and so the less that Japanese companies have to charge to sell their products, making them more competitive. Not only that, but a weaker yen makes the carry trade even more profitable for investors, so it encourages them to borrow and sell even more yen, a positive-feedback cycle.

When times are good, this is all and well, and the carry trade has been a great help to Japan for the last 20 years. The downside is when it backfires, it backfires hard: when there are no profitable investments to be found anywhere in the world, as was the case after the economic meltdown after the last 18 months, not only do investors stop borrowing yen, but they need to convert their money back into yen to pay back their Japanese loans. Hence, when there were few money-making opportunities to be had last year, everyone converted their overseas currency back into yen, driving the exchange rate up immensely (since summer 2007, where 1 dollar traded for ¥124, the rate plummeted to a low of ¥85 last November, and has since crept up to only ¥94). This is a major problem for Japan: with a stronger yen, Japanese companies have to either accept lower revenues (since the dollars of their customers translate to fewer yen), or increase their prices. This is why Japan has been hit doubly-hard by the recent economic turmoil.

Obviously China is not interested in seeing the same thing happen to them, which is in itself a perfectly legitimate reason for proper fiscal policy: the WTO doesn’t say that countries can’t be involved at all with their nation’s exchange rate, only that they cannot get involved so heavily that it “excessively distorts” what the value of that currency would be if only supply-and-demand economics were involved, with the aim of unfairly competing with other countries. The problem is that “excessively distorts” is a purely subjective measure. Countries like the United States believe China is excessively distorting the value of the yuan; China, of course, does not. Third parties are more mixed on the matter: The Economist says the renminbi is overvalued by about 20%, which is a significant amount, but nowhere near the 40% that the US tends to claim. China has slowly but steadily allowed the yuan to increase in value for the past few years, but the total change since 2005 has only amounted to about 16%.

If the Times is to be believed though, there’s about to be a significant policy shift, which may see the yuan increasing in value at a faster clip in the near future. The important thing to keep in mind here is that China is probably not doing this because of the pressure placed on them by the West. As the concept of “saving face” is extremely important to figures of authority in China, it is vital that they do not appear to their populace to be caving in to Western demands (the Chinese public is quick to notice and anger about such things). Instead, their primary motivation is probably economic: although the weak yuan has been a great help to China for the last couple decades, it’s starting to show some downsides too. Inflation in China has been higher than what the government would like it to be, and real-estate prices are skyrocketing. The problem is that with a weak yuan whose value is artificially constrained by policy, it is difficult for China’s central bank to manage these problems effectively; they are able to take much more action if the value of the currency is flexible with respect to the performance of the markets. That’s probably the real issue here.

At any rate, assuming the Times’ report is even accurate, the change is unlikely to be dramatic, at least for the time being.

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