Is China keeping its currency undervalued a double edged sword for China?

April 23, 2006 7:10 AM

Is China keeping its currency undervalued a double edged sword for China?

Economic question

Many experts seem to think that China purposefully keeps its currency undervalued in order to make its goods cheaper for exporting and its economy growing.

Assuming this is true, is there going to be any short term and long term negative consequences for China's economy with this policy?

If there is no downside to China for keeping the status quo, why would they want to revalue their currency upwards?

The only potential benefit I can see for China to revalues its currency upwards is to help fight domestic inflation. Because a stronger Yuen would bring in more imports and this could put a dampening effect on the ability of the competing local manufacturers to raise their prices , in order to fight for domestic customers to compensate , among other things, the loss of export orders.

From what I know , revaluing a country's exchange rate upwards by increasing the money supply could cause interest rate to fall , less incentive to save and more incentive for citizens to borrow money for consumption and investment and the internal economy to grow even faster , possibly eventually leading to overheating of the economy and runaway inflation; not to mention that a stronger currency could hurt China's exports?

Is there any other forum where I can ask economic related questions? I am studying economics on my own.

posted by studentguru to grab bag (28 comments total)

Absolutely. Their economy is in a bubble, much like the US in the late 1990s, but worse.

To keeping their currency low, they have to print lots of it to buy ours. Since we're printing money like crazy, they have to print like crazy too. In essence that just exports our inflation. With all the money available in China, it's easy to get loans. The state-run banks are free and easy with money, and more than happy to prop up failing enterprises. So too much stuff gets built. And there is always massive fraud and corruption in bubbles.

When the Chinese bank stops printing as much money, a contraction within China will start. The overbuilt capital assets will have trouble paying for themselves. Insolvent businesses will fail, but many businesses that would have been fine in normal economic times will also fail. The net damage will be terrible.

There are no good solutions to economic bubbles. The only solution is not to have one. Their bubble is a Siamese twin to our debt-driven one, which is ending.

I don't think the game can last more than about two more years, tops. The housing ATM is this country shutting down, and unless the Fed comes up with some other, even more unhealthy, way to inject lots of cash into the system, both countries are likely to go into a truly profound, long-term contraction.

China will suffer much less than we will, being a creditor nation.

Prudent Bear used to have really good forums, although I haven't been there in ages.
posted by Malor at 8:17 AM on April 23, 2006

Sigh. "In keeping" or "To keep".

*reminds self to proofread more*

Also, another really good resource for economic data: itulip.com.
posted by Malor at 8:29 AM on April 23, 2006

Thank you very much, Mator.

To keeping their currency low, they have to print lots of it to buy ours.

Why would they need to print more money when their goods are being sought after by Americans?
posted by studentguru at 8:40 AM on April 23, 2006

Money is supply and demand, just like other commodities. (which is why it's kind of amusing to see people demonize gold as 'just a commodity', because that's all money IS... the most marketable commodity. Paper money is a commodity too.) (note: that is Mises' definition of money. Not everyone uses that definition.)

If I buy something Chinese, removing the middlemen for clarity, I trade dollars to a Chinese manufacturer for a product. He will probably immediately convert dollars into renminbi, to pay his workers and buy new materials. This makes more dollars available, and fewer renminbi. If this transaction happens often enough, it will gradually strengthen their currency and weaken ours, because it increases the supply of dollars and decreases that of renminbi.

We're currently running a deficit with China to the tune of something like 200 billion dollars a year. In a free market system, this would dramatically affect the value of the dollar; the world would be swimming with them. But the Chinese central bank is 'soaking up' the excess dollars by printing renminbi to buy dollars. This makes more of the Chinese currency available, and makes it much easier to get loans. If money is available, banks want to lend it out, because that's how they make a profit. So credit standards drop, and marginal borrowers can get loans. The new money in the system causes economic expansion. If there's enough new money, the economy can go into boom mode. The Chinese economy has been WAY past 'boom mode' for, geeze, the last eight or ten years now. Booms are bad for an economy, because they reward imprudent risk-taking, and encourage corruption.

So the overall net effect, kinda-sorta, is that we're buying Chinese goods with worthless paper, propped up by their central bank. Their currency is easy to get, so they are overbuilding factories to chase dollars that they don't realize are essentially worthless. The Chinese central bank is accumulating hundreds of billions of dollars, but their businessmen probably don't even realize it.

When their central bank stops intervening, as someday it must, suddenly all those factories built to chase dollars will be getting dollars worth a lot less than before. They'll be forced to raise prices, and many will go out of business. In the US, this will start to show the inflation that's already deeply embedded into the system; it will finally become visible to the average Joe on the street.

There are two reasons that the inflation isn't visible to most people now: our government is massively fudging the inflation numbers, and the Chinese and Japanese governments are trying to keep their currencies low by buying dollars. They will not be able to do that forever.
posted by Malor at 9:05 AM on April 23, 2006

I'll concur with Malor and add that in the long-term as the renminbi inflates Americans will just move their manufacturing to countries where it is cheaper to operate. We'll still see cheap imports, and as China isn't necessarily a large capital inflow in the United States, we will still see that side of the balance of payments pay for our cheap imports.
posted by geoff. at 9:14 AM on April 23, 2006

To piggyback on the question, can any of you fx gurus recommend a book on currency and foreign exchange?
posted by Mid at 10:06 AM on April 23, 2006

I'm sorry, Mid, that's out of my knowledge range. I do know that there's nothing more dangerous than currency trading. Because there's not much in the way of real value to any of them, they're as constant as a politician's opinion.

You can get lucky, but making a profit consistently at that game is incredibly difficult.
posted by Malor at 10:17 AM on April 23, 2006

One way to look at it is that China is taxing its citizens in order to keep them employed. By keeping the Rmb low, citizens can buy fewer foreign goods, effectively a tax. But by keeping the Rmb low, it can sell more goods to foreigners, which keeps them employed.

The huge risk that China is taking is that the imbalance in payments is forcing them (and other countries) to hold huge amounts of low interest US bonds. If at some point these countries lose confidence in those bonds, there could be a run on the bank in which everyone tries to dump their bonds at the same time. This will cause a huge increase in interest rates, making their bonds nearly worthless.
posted by JackFlash at 10:19 AM on April 23, 2006

Malor -- I just meant for informational purposes; I don't want to trade. Although it has crossed my mind that it might make sense to move some portion of my savings to Australia or NZ or something. But in a bank account over there, not in any kind of currency day trading.
posted by Mid at 10:21 AM on April 23, 2006

malor, there's one question i've wondered about - why do some call the chinese currency the yuen and others the renminbi?
posted by pyramid termite at 10:55 AM on April 23, 2006

Yuan literally refers to a round object. Renminbi means "people's currency," because, you know, it is the People's Republic of China, what with everything belonging to the people and all.
posted by oaf at 11:05 AM on April 23, 2006

Malor is close, but the Chinese aren't really printing a whole bunch of RMB to buy dollars. They are trading goods for dollars, and with those dollars, they buy assets, both tangible (Boeing airplanes), and financial (US bonds, IBM's hardware division).

The PBC (Chinese Central Bank) has an easy time keeping the peg, because it has a lot of dollar reserves, and (practically) unlimited Yuan reserves. Any time someone wants to trade dollars for Yuan or vice-versa, it has a big supply of both, and can make either side of the market. Hence the peg.

Another way in which this market isn't exactly free (FYI) is that China has in place domestic currency controls. Some experts have suggested that relaxation of these controls will unleash a pent-up demand for dollars among Chinese citizens, and the Chinese Central bank will be fighting to keep the dollar down, rather than fighting to keep the RMB down (as it has over the past few years).
posted by Kwantsar at 11:14 AM on April 23, 2006

The central bank doesn't deal in goods, it deals in yuan/renminbi. Individual Chinese companies trade goods for dollars, and then trade a good chunk of them for their own currency, to pay their workers and their internal suppliers. The remaining dollars are spent on goods from other countries, including America.

Our total trade deficit, last year, was $725 billion. That means we shipped 725 billion dollars overseas, in exchange for goods. That's a huge oversupply, and should be sending the dollar into the toilet. The reason it's not is because the Japanese and Chinese central banks (primarily) are buying up dollars with their own currencies.

The Chinese intend to maintain a 'peg' to the dollar, and in THEORY will make either side of the yuan/dollar trade. But in actual PRACTICE, they end up selling a lot of yuan and buying a lot of dollars. Same with the Japanese, although I don't think they have an official peg. (not sure).

Again, central banks don't deal with goods, only currencies. Saying they're trading goods for dollars is just wrong.

I'm sure the Chinese central bank would love it if the Chinese people wanted dollars. It has accumulated many hundreds of billions. Lightening up would probably be very good for their balance sheet. It would really suck for the Chinese people, once the rush was over and the inflation restarted, but the bank would be in much better shape.
posted by Malor at 12:06 PM on April 23, 2006

Again, central banks don't deal with goods, only currencies. Saying they're trading goods for dollars is just wrong.

No one said that. And central banks deal with financial assets. Not just currency, but also debt. Furthermore, the people's bank of China holds (held?) 600 tonnes of gold, and owns stakes in various commerical and construction banks.
posted by Kwantsar at 12:51 PM on April 23, 2006

When the Chinese bank stops printing as much money, a contraction within China will start. The overbuilt capital assets will have trouble paying for themselves.

On the other hand, capital assets built with $45/bbl oil look like a significantly better value than capital assets built when oil is $100/bbl. The rising energy prices will both brake the economy and raise the present value of these capital assets. China knows this.
posted by ikkyu2 at 1:09 PM on April 23, 2006

Kwantsar: You say 'No one said that', but I was referring to this quote: "Malor is close, but the Chinese aren't really printing a whole bunch of RMB to buy dollars. They are trading goods for dollars, and with those dollars, they buy assets, both tangible (Boeing airplanes), and financial (US bonds, IBM's hardware division)."

I'm talking about the central bank and what it's doing. You came back with, essentially, 'no, that's not quite right, they're selling goods in exchange for dollars'. Since I'm talking about the central bank, and you phrased your reply as a contradiction, it seems reasonable to assume you're talking about the same thing. If you weren't, that's fine, it's just a misunderstanding. But I stand behind the fundamental assertion that the Chinese central bank is soaking up excess dollars.

Also, remember that the deficit figures include many forms of repatriation. The Chinese bought a bunch of American assets in February, for instance, and that dropped the trade deficit pretty substantially that month. So they're already counting asset purchases, at least some of the time. (although god knows how trustworthy the figures are.)

You're correct re:not just currencies. I oversimplified. But they definitely don't deal with goods.

ikkyu2: But if the economy brakes, then demand for goods slows. A capital asset built for a third less is great... but a capital asset that makes things that nobody wants is worthless. If you can orchestrate events so that you pay $45/bbl for the energy to build assets, and can then sell the products in a robust $100/bbl environment, you make out like a bandit... but there's also a chance you can't sell enough widgets for the asset to be profitable anymore. $100/bbl oil will be a tremendous brake on the economy, if it happens anytime soon.

The Chinese certainly aren't stupid, but it seems unlikely that anyone can model the global economy _that_ well.
posted by Malor at 2:16 PM on April 23, 2006

Thank you very much to everyone who wrote, I am a bit clearer now.

I actually read the following posts before I posted my original question.

Mid you might want to check them out and look for some ideas about moving your savings overseas:

http://ask.metafilter.com/mefi/18508



http://ask.metafilter.com/mefi/21514

http://ask.metafilter.com/mefi/7021

http://www.metafilter.com/mefi/43625

As for making your savings in foreign currency denominations, a couple of the posts from above talked about http://www.everbank.com/
posted by studentguru at 2:39 PM on April 23, 2006

it might make sense to move some portion of my savings to Australia or NZ or something.

You want to keep an eye on Australia and NZ. Ditto Iceland

And in case that wasn't enough to worry about....

(Nice job, malor, by the way. You should post more often. Seriously.)
posted by IndigoJones at 3:21 PM on April 23, 2006

One complicating factor here is that the US$ is defacto the world currency.

Irrespective of any issues of trade imbalances, it's necessary for the central bank of a nation to increase the money supply as the economy of that nation grows. If they don't, you can get a problem with liquidity which chokes the economy. Back in the middle ages, when precious metal was "money", they had that problem and their economies couldn't expand fast enough until after a huge silver strike at Joachimsthal in Bohemia.

Then, later, the massive influx of precious metals from Central America resulted in the opposite problem: too much money resulting in inflation.

Because the US$ is effectively the world currency, if the US "solved" its trade imbalance problem and balanced its trade, it would mean that the world's dollar supply would stop growing, and the world economy could conceivably stall as a result of liquidity problems.

Oddly enough, that means that international trade actually requires the US to keep running a trade deficit. Whether it should be as large as it has been is another question, of course.
posted by Steven C. Den Beste at 4:46 PM on April 23, 2006

"it might make sense to move some portion of my savings to Australia or NZ or something"

I would be very cautious about that.

Here in NZ our dollar has recently dropped against the US, and may yet have a lot further to go. It's really only our high domestic interest rates that have kept it so high for so long. You and a bunch of Japanese housewives and Belgian dentists may be about to discover what happens to yield hogs in minor currencies.

More generally NZ and Australian currencies are sensitive to world commodity prices in meat/dairy and metals/minerals respectively. If the China-US folie-a-deux collapses, who's gonna buy our stuff, and who will want our poxy South Pacific Pesos?
posted by i_am_joe's_spleen at 4:54 PM on April 23, 2006

I don't think that's true, Stephen. Countries have their own currencies for local growth. Whatever the supply of US$ actually is, the world will adapt. Even if there were only ten US dollars in existence, they could make it work with fractions of a cent or somesuch.

Likewise, it's pretty easy to work around the lack of physical gold; temporary notes were once very common. Gold would be checked in 'at the door' to merchant halls, and scrip issued. Trading would happen via the scrip, and then everyone would cash out at the end and go home. Blaming slow growth on insufficient gold is most likely too simplistic.

Money is just the most marketable commodity. There's nothing really _that_ special about it. If a given commodity (say, gold) is too scarce to serve as money, something else will take its place.

Governments meddle in money primarily because it gives them power. They'll point to the evil days of pre-fiat money, where we had booms and crashed... without bothering to mention that immature economies can do that with or without fiat money. And they carefully don't mention that historically, abuse of the currency has caused many countries, even empires, to collapse.

U.S. Dollar, n: A politician's promise to pay nothing on demand.
posted by Malor at 5:23 PM on April 23, 2006

Actually, the foundation of the value of the US$ is a surprising one.

Precious Metal fans, the ones who demand that we return to the gold standard or the silver standard, try to claim that the only reason a currency is trusted is because there's "something" behind it -- but while there's some truth to that, there isn't much.

Anyway, the reason that we all treat US$ as being worth something is because the US government will accept US$ as payment for taxes. THAT is what keeps the value up.

In other words, U.S. Dollar, n: A politician's promise to take it from you on his demand.
posted by Steven C. Den Beste at 5:53 PM on April 23, 2006

You forgot the legal tender laws. That's the primary reason, not the taxes.
posted by Malor at 6:35 PM on April 23, 2006

I'd like to add my thanks to Malor for his extremely enlightening contributions to this thread. I now feel I understand this stuff a lot better.
posted by languagehat at 5:51 AM on April 24, 2006

The answers above all take a macro view of the problem. In terms of harm to individual Chinese people, the current policy makes imported goods more expensive. So if a Chinese person wants to buy something that is made in America and they want to pay for it with Chinese currency, they will pay a lot more for than they should.

While this is a burden for individual Chinese people, it actually helps their country accumulate dollars, which is good in the long run.

This is the mirror image of the situation in American. Here, American consumers pay a lot *less* for Chinese goods than we should. Economists consider that a "benefit" for U.S. consumers, even though the macro effect is to deplete our savings and manufacturing infrastructure and send them all over to China.
posted by alms at 7:24 AM on April 24, 2006

Brilliant thread. I have a couple of tangental questions if anybody is still listening:

1. What would happen if China and Japan dumped their US$ reserves?

2. Is it true that the US$ is the de facto world currency because oil is priced in dollars? If so, if oil is valued in € how would this change the world economy? Also, what happens when oil becomes an untenable energy source (that is, becomes too expensive to fuel the global economy)?


ps) I've always liked William Gibson's description of money: "Money is a consensual hallucination"....
posted by sic at 10:42 AM on April 24, 2006

sic,

In response to your question 1, I think this post by Nouriel Roubini would help.

http://www.rgemonitor.com/blog/roubini/91198
posted by studentguru at 10:58 AM on April 24, 2006

What would happen if China and Japan dumped their US$ reserves?


As I mentioned above, it would be a disaster for both China and the US. Right now the US is running huge budget deficits that are funded by bonds purchased by China and Japan. Since there is a trade imbalance, they have lots of dollars to loan to us. Fortunately for the US, this demand for bonds keeps interest rates low, meaning that the US is getting pretty much a free ride on its debt. This works only as long as they have confidence in the US dollar.

Now what happens if someone, Japan, China, etc starts to get nervous and decides to sell off some of their US bonds. An oversupply of bonds means that the US has to raise interest rates on bonds to get someone to buy them. As interest rates go up, the value of current bonds goes down. After all, who would want to hold old bonds at 4% interest when new bonds are paying 10%. At this point there could be a panic rush for the exits as everyone tries to dump their bonds before the price drops too low. Bonds flood the market and the US has to raise interest rates sky high to finance its current debt. The result could be a worldwide recession.

Everyone is hoping for a soft landing -- that China will slowly raise the Rmb and the dollar will decline. This makes US goods cheaper and China's goods more expensive, restoring the trade imbalance. But most analysts seem to think that even a 20% decline in the value of the dollar would have a minimal impact on the trade deficit.

The only real solution is for the US to get its domestic budget in order so that it doesn't have to borrow so much. This will keep interest rates low no matter what China does with its bonds. Another piece of the puzzle is reducing oil imports, the fastest growing portion of the trade imbalance. This might be accomplished by raising gas taxes by a dollar or two. This has the double effect of reducing demand for oil and also helping balance the budget deficit. But there's little chance of happening in today's political climate.
posted by JackFlash at 11:37 AM on April 24, 2006