The Mechanics of a Fixed Exchange Rate
By Greg Mankiw
A student emails me a question about China's exchange-market intervention:
Could you outline step-by-step how, say, $3000 spent by me on a Lenovo computer (Chinese) eventually becomes $3000 worth of debt (US Treasury bonds) owed by the United States to the Chinese government?
To keep things simple, let's suppose that China is fixing its exchange rate. (That was exactly true until recently, and is still approximately true, although China now allows some flexibility.) Here is how the situation unfolds:
1. You (an American) buy a Chinese export. To do that, you (or your retailer) has to pay the Chinese company in yuan, the Chinese currency. You therefore turn to the foreign-exchange market, supplying dollars and demanding yuan.
2. Your transaction puts downward pressure on the value of the dollar relative to the yuan.
3. The Chinese central bank, seeing the pressure on the exchange rate, intervenes in the foreign-exchange market. To keep the yuan from appreciating, it supplies yuan and demands dollars.
4, The Chinese central bank has now acquired some U.S. dollars. Rather than holding these newly acquired assets in cash, it prefers interest-bearing securities, so it uses these dollars to buy U.S. Treasury bills.
In the end, your decision to buy a Chinese export induces China to hold more U.S. government debt.
Step 3 is precisely what China critics object to. See this post for a discussion of the controversy.
The Chinese Exchange Rate
An ec 10 student draws my attention to a recent editorial in the NY Times about the Chinese exchange rate. Here is an extract:
Mr. Schumer Goes to China
The good news is that Senators Lindsey Graham and Charles Schumer have started to inch away from their misguided attempt to club China for its currency policies. At the end of a fact-finding trip last week, Mr. Schumer told reporters he was no longer sure he would push for a vote to impose tariffs on Chinese imports into the United States....
China clearly needs a more flexible currency, both for the sake of trade relations and to gain more control over its economy. But moving the yuan could cause pain in the United States. America's lack of savings is the biggest contributor to global imbalances, making it necessary to "import" billions of dollars of foreign capital daily to cover budget and trade deficits. China is America's second-most-important lender, after Japan.
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The student asks for some clarification about this issue. As it turns out, I have recently written a case study on exactly this topic for the new edition of my intermediate macroeconomics textbook, which is due for publication in about a month. I happy to share a sneak preview with you:
Case Study
The Chinese Currency Controversy
From 1995 to 2005 the Chinese currency, the yuan, was pegged to the dollar at an exchange rate of 8.28 yuan per U.S. dollar. In other words, the Chinese central bank stood ready to buy and sell yuan at this price. This policy of fixing the exchange rate was combined with a policy of restricting international capital flows. Chinese citizens were not allowed to convert their savings into dollars or Euros and invest abroad.
Many observers believed that by the early 2000s, the yuan was significantly undervalued. They suggested that if the yuan were allowed to float, it would increase in value relative to the dollar. The evidence in favor of this hypothesis was that to maintain the fixed exchange rate, China was accumulating large dollar reserves. That is, the Chinese central bank had to supply yuan and demand dollars in foreign-exchange markets to keep the yuan at the pegged level. If this intervention in the currency market ceased, the yuan would rise in value compared to the dollar.
The pegged yuan became a contentious political issue in the United States. U.S. producers that competed against Chinese imports complained that the undervalued yuan made Chinese goods cheaper, putting the U.S. producers at a disadvantage. (Of course, U.S. consumers benefited from inexpensive imports, but in the politics of international trade, producers usually shout louder than consumers.) In response to these concerns, President Bush called on China to let its currency float. Charles Schumer, Senator from New York, proposed a more drastic step— a tariff of 27.5 percent on Chinese imports until China adjusted the value of its currency.
In July 2005 China announced that it would move in the direction of a floating exchange rate. Under the new policy, it would still intervene in foreign-exchange markets to prevent large and sudden movements in the exchange rate, but it would permit gradual changes. Moreover, it would judge the value of the yuan not just relative to the dollar but relative to a broad basket of currencies. Five months later, the exchange rate had moved to 8.08 yuan per dollar—a 2.4 percent appreciation of the yuan, far smaller than the 20 to 30 percent that Senator Schumer and other China critics were looking for.
Was the yuan really undervalued by such a large amount? To answer this question, we must first ask, compared to what? The critics of Chinese policy may well have been correct that the yuan would have appreciated substantially if the Chinese had stopped intervening in foreign-exchange markets while keeping their other policies the same. But a movement to a fully floating exchange rate could well have been coupled with a movement toward free capital mobility. If so, the currency implications could have been very different, as many Chinese citizens might have tried to move some of their savings abroad. While the central bank would no longer have been demanding dollars to fix the exchange rate, private investors would have been demanding dollars to add U.S. assets to their own portfolios. In this case, the change in policy could well have caused the yuan to depreciate rather than appreciate.
As this book was going to press, it was unclear whether China would continue on the path toward a floating exchange rate and freer capital mobility. The issue remains a topic of intense international negotiation. |
