No more fixed USD-Yuan exchange rate

July 21, 2005 6:16 AM

Question for our MeFi economists. What impact might China's re-valuing of the yuan have on the economy, trade deficit, gov't debt held by China, etc.?

With my own rather limited knowledge of economics, it seems to me that while this could make US goods more competitive abroad, it seems to open up a whole other set of potential issues. As yuan rises (as seems to be indicated), this makes US Bonds and Treasury securities less attractive to the Chinese Government, which makes it more difficult for the US Government to run deficits, etc. Any view on this? Why was the US Treasury department pushing for this? What are the short and long term risks and benefits?

posted by psmealey to work & money (6 comments total)

The yuan is being revalued in part because the Chinese want to rebalance their economy between exports (supported by a cheap yuan) and domestic development (which, because it requires more imports of foreign goods and services, is supported by a rich yuan).

Reducing the reliance upon exports is a smart move for the Chinese because they know that no one country ever has a guarantee on being the low-cost manufacturing powerhouse. Vietnam is already cheaper than China, and Africa promises to undercut everyone in Asia if they can get their infrastructure and rule-of-law problems in order.

The U.S. government will have to pay a little more interest on its debt than it would otherwise, but that might be made up in deficit terms by higher tax receipts due to more domestic manufacturing.

You'll want to watch what Wal-Mart does over the next few days. I expect they're going to say that they won't pay their Chinese vendors one (US$) penny more per unit than they're paying now, and if the Chinese vendors have to swallow a reduced (yuan) profit margin, tough luck.
posted by MattD at 6:58 AM on July 21, 2005

MeFi
posted by psmealey at 6:58 AM on July 21, 2005

ooo, monetary economics! I never worked on the China-US debacle, so I can only give you a general idea on the topic, I'm afraid...
First off: each country or group of countries has a central bank which has, amongst other mostly idiosyncratic duties, the obligation to take care of the national currency and inflation rate. Central banks have a certain amount of ways (called "instruments" in the jargon) to to do this, like setting a certain base interest rate (for the US, that's the rate Greenspan announces to much anticipation) and/or interventions on the money market and/or modifying their foreign currency reserves and/or making loud noise about this or that to attract the market's attention, etc, etc.
anyway, when the media writes "China pegs the yuan to the dollar", that means that the Chinese Central Bank adjusts it's instruments to mimic as closely as possible the fluctuations of the american currency, it "targets the US exchange rate".

When a central bank targets a given exchange rate, it tries to "import" the anchor country's inflation. China "imports" the US's low and stable inflation and maintains a favourable exchange rate with the US. The good part about this type of regime is that it ensures economic stability which is primordial in a developing country like China. But once the country is sufficiently developed, the disadvantages of this regime overtake the advantages.
One of the greatest disadvantages is that currency pegs weaken the autonomy of the Chinese central bank. Because its domestic interest rates must mirror the rates of the anchor country, the central bank can't react very well to domestic demand or supply shocks. Also, any chocs affecting the anchor country will be "imported" to the country whose currency is fixed. (Not to mention the possibility of speculative attacks on the domestic currency)...

So, China's central bank announced it's moving towards a different regime of exchange-rate targeting known as the "currency board". It's still anchoring its currency to other currencies (it's not free floating), but instead of anchoring it's currency to the USD, a single, transparent low-inflationary, high-central-bank-credible country, it's anchoring its currency currencies to a basket of currencies, each having a certain level of (atm unknown) influence on the Chinese yuan.
In "textbook economics", one often comes across this type of exchange-rate regime when dealing with measures to stabilise a country in the midst of an economic crisis, because currency boards have in the past stabilised the exchange rate, the inflation rate and the currency reserves at the same time. But obviously China is not in an economic crisis.
My uninformed opinion would guess that China's central bank is moving from the peg to the currency board to better prepare the markets for an eventual float some years down the line. My immediate guess is that China will experience an accelerated inflation for at least the end of the year, if not for more. This won't affect the US that much, unless inflation gets so bad that chinese consumers can't afford US products anymore. But then again, the US probably already has its factories in China, so it's already working on chinese terms. Worse case scenario: If raging inflation in China makes salaries and prices expensive in China, any foreign or chinese factory in China will be more and more expensive to upkeep and that expense will be passed along to the final consumer. (ie: anything made in China will get more expensive for American consumers). But eventually, the unsustainable factories will relocate to a cheaper place like, South Sudan, and prices will fall.
posted by ruelle at 8:51 AM on July 21, 2005

It will make cheap imports into the US more expensive, so look for price increases. It may make US exports to China cheaper thereby helping agribusiness, Boeing, and a few other corporations.

End result: Costs go up for everyone in the US but the benefits accrue to only a small noisy group of large companies.

Stock up on your WallMart supplies now while prices last.
posted by mono blanco at 6:53 PM on July 21, 2005

A really good explanation of this from my livejournal friendslist.
posted by ikkyu2 at 7:34 AM on July 25, 2005

A really good explanation of this from my livejournal friendslist. If you scroll down, unfortunately, you will be exposed to my own paranoid ideations on the topic.
posted by ikkyu2 at 7:35 AM on July 25, 2005