What's the problem with China pegging its currency to the dollar?
May 5, 2004 9:00 AM Subscribe
Economics question. Why is it problematic for a country like China to peg its currency to the dollar?
Hmm...
I think the reason that the US wants (wanted?) China to unpeg the Yuan from the dollar was that the Yuan was artificially weak (which helped fuel China's economic growth). Unpegging the Yuan from the dollar would have allowed it to rise against the dollar - which would have improved China's ability to import US goods, while making chinese exports more expensive (and therefore less atrractive) in the US. Therefore, (in this simplistic analysis), unpegging the Yuan from the dollar would benefit the US, and hurt China, economically.
posted by kickingtheground at 9:53 AM on May 5, 2004
I think the reason that the US wants (wanted?) China to unpeg the Yuan from the dollar was that the Yuan was artificially weak (which helped fuel China's economic growth). Unpegging the Yuan from the dollar would have allowed it to rise against the dollar - which would have improved China's ability to import US goods, while making chinese exports more expensive (and therefore less atrractive) in the US. Therefore, (in this simplistic analysis), unpegging the Yuan from the dollar would benefit the US, and hurt China, economically.
posted by kickingtheground at 9:53 AM on May 5, 2004
Another potential problem with pegging currencies is that it exposes you to manipulation by currency arbitragers. I admit I'm foggy on the exact mechanisms at work, but if an arbitrager knows you're going to prop up your currency, he can buy it up in huge volumes and dump it (exploiting tiny variations in the exchange rates of different markets); normally dumping it would push your currency's value down, so you'll need to do something (raise interest rates) to keep it up. This winds up hurting your economy, which tends to weaken the currency more, vicious cycle ensues.
This hurt Argentina, which was dollar-pegged, a few years ago. It also created a huge problem in the EU: before monetary integration, the countries involved had to trade currencies within narrow exchange-rate bands; arbitragers exploited this and basically forced the whole system to collapse.
posted by adamrice at 10:16 AM on May 5, 2004
This hurt Argentina, which was dollar-pegged, a few years ago. It also created a huge problem in the EU: before monetary integration, the countries involved had to trade currencies within narrow exchange-rate bands; arbitragers exploited this and basically forced the whole system to collapse.
posted by adamrice at 10:16 AM on May 5, 2004
In a nutshell, instead of having billions of people determine the value of a currency, you have a few central planners. When the planners are wrong, the consequences can be disastrous.
As an aside, I've seen more than one currency trader/analyst speculate that removing the peg and restrictions will push the renminbi down, not up, because everyone in the countryside wants to hold dollars.
In kickingtheground's analysis (which is widely held), it's important to remember that there ae two competing interests-- domestic manufacturers and their employees (who profit from expensive foreign goods), and domestic consumers (who profit from inexpensive foreign goods).
posted by Kwantsar at 10:41 AM on May 5, 2004
As an aside, I've seen more than one currency trader/analyst speculate that removing the peg and restrictions will push the renminbi down, not up, because everyone in the countryside wants to hold dollars.
In kickingtheground's analysis (which is widely held), it's important to remember that there ae two competing interests-- domestic manufacturers and their employees (who profit from expensive foreign goods), and domestic consumers (who profit from inexpensive foreign goods).
posted by Kwantsar at 10:41 AM on May 5, 2004
Pegging the currency is good when the country is not economically stable (e.g. high inflation) - it’s the same kind of reason that makes people putting money into gold. When things are not that bad, pegging the currency does not help; the simplest way to look at it is that China, by using this policy, looses one degree of freedom. When one looses an opportunity, that person/country is theoretically worse off.
From a mathematical perspective, one tries to maximize his/her/its welfare while being restricted by several constrains. When you add one constrain, you loose one degree of freedom. The solution space becomes much more smaller (several states cannot be reached, e.g. x has to be less than 0) and the new optimum might not be as good as the previous optimum, without the extra condition.
The interesting question is why people/countries prefer to give up these degrees of freedom by pegging the currency / following the boss exactly / etc.? And, even more interesting, is that sometimes one is better off by giving up that opportunity!
For a society, it is not easy to find the optimum configuration – remember, this is a dynamic equilibrium. The simplest way is to imitate somebody else, use their solution. Or, maybe simplifying the problem will help: keep some of the variables constant (e.g. peg the currency) and tweak the others – the problem is more manageable now. One is much better off finding the solution of a simple problem rather than playing with more variables.
posted by MzB at 10:46 AM on May 5, 2004
From a mathematical perspective, one tries to maximize his/her/its welfare while being restricted by several constrains. When you add one constrain, you loose one degree of freedom. The solution space becomes much more smaller (several states cannot be reached, e.g. x has to be less than 0) and the new optimum might not be as good as the previous optimum, without the extra condition.
The interesting question is why people/countries prefer to give up these degrees of freedom by pegging the currency / following the boss exactly / etc.? And, even more interesting, is that sometimes one is better off by giving up that opportunity!
For a society, it is not easy to find the optimum configuration – remember, this is a dynamic equilibrium. The simplest way is to imitate somebody else, use their solution. Or, maybe simplifying the problem will help: keep some of the variables constant (e.g. peg the currency) and tweak the others – the problem is more manageable now. One is much better off finding the solution of a simple problem rather than playing with more variables.
posted by MzB at 10:46 AM on May 5, 2004
I'm no economist, but it seems like there's a pretty straightforward reason not to peg a the yuan to the dollar at some ratio: China's economy (and money supply) isn't pegged to the American economy at some ratio.
If you think of economies as systems, what this does is bolt two pieces (variables) together which require a certain freedom of movement (variability). If they are forceibly synchronized, the corresponding strain moves elsewhere in the system.
posted by majick at 3:20 PM on May 5, 2004
If you think of economies as systems, what this does is bolt two pieces (variables) together which require a certain freedom of movement (variability). If they are forceibly synchronized, the corresponding strain moves elsewhere in the system.
posted by majick at 3:20 PM on May 5, 2004
There's a very very good reason why you don't want to peg the currency to the dollar. Let's look at what happened in Argentina:
In (IIRC) 1991, Argentina decided to peg its currency to the dollar in order to stave off inflation (the U.S. was seen as a stable currency, so tying the two would thus mean Argentina's peso would also be stable). Unfortunately, pesos were not treated like dollars on the foriegn exchange market.
People like dollars overseas -- they're seen as a reliable form of currency that won't devalue overnight (as has happened in a lot of Asian and S. American countries). Basically, you could never get as much trading pesos as you could dollars, even though they were, for all intents and purposes, the same thing. Since the peso was at a high valuation, Argentina's exports became very expensive and their imports very inexpensive.
The U.S. went through the tech boom in the 90's, and the growth rates were around 5%, but in Argentina, you have an ever increasingly "expensive" peso, but no actual growth to balance it out. Tie this in with the high price of Argentina's exports, and this led to a serious drop in tax revenue, which led to huge deficits, which increased the recession Argentina was facing in the late 90's.
Now, if Argentina had kept a floating currency, there could have been all sorts of things they could have done to devalue the peso (and thus increase the attractiveness of their exports, which would have staved off the recession). Instead, businesses and government agencies had to cut jobs in order to stay in business. No jobs + expensive goods & services = civil unrest.
Anyway you can see where all of this led by doing a Google search for "Argentina Riots". It ain't pretty.
posted by Civil_Disobedient at 5:15 PM on May 5, 2004
In (IIRC) 1991, Argentina decided to peg its currency to the dollar in order to stave off inflation (the U.S. was seen as a stable currency, so tying the two would thus mean Argentina's peso would also be stable). Unfortunately, pesos were not treated like dollars on the foriegn exchange market.
People like dollars overseas -- they're seen as a reliable form of currency that won't devalue overnight (as has happened in a lot of Asian and S. American countries). Basically, you could never get as much trading pesos as you could dollars, even though they were, for all intents and purposes, the same thing. Since the peso was at a high valuation, Argentina's exports became very expensive and their imports very inexpensive.
The U.S. went through the tech boom in the 90's, and the growth rates were around 5%, but in Argentina, you have an ever increasingly "expensive" peso, but no actual growth to balance it out. Tie this in with the high price of Argentina's exports, and this led to a serious drop in tax revenue, which led to huge deficits, which increased the recession Argentina was facing in the late 90's.
Now, if Argentina had kept a floating currency, there could have been all sorts of things they could have done to devalue the peso (and thus increase the attractiveness of their exports, which would have staved off the recession). Instead, businesses and government agencies had to cut jobs in order to stay in business. No jobs + expensive goods & services = civil unrest.
Anyway you can see where all of this led by doing a Google search for "Argentina Riots". It ain't pretty.
posted by Civil_Disobedient at 5:15 PM on May 5, 2004
Response by poster: So... is the consensus that it's ok -- maybe even advantageous -- for a small country/economy to sync up with the dollar, but things get ugly when you're talking about larger, China-sized powers?
I guess what I'm most interested in here is why it would adversely affect the US. Would it be possible for China to flood the market with the dollars it has stashed away, thus devaluing the dollar further?
CD -- That's an interesting take... and I'll have to read up more about Argentina. Out of curiosity, though, what would have happenned had they not gone with the dolllar? Were they only prolonging the inevitable?
posted by ph00dz at 6:59 PM on May 5, 2004
I guess what I'm most interested in here is why it would adversely affect the US. Would it be possible for China to flood the market with the dollars it has stashed away, thus devaluing the dollar further?
CD -- That's an interesting take... and I'll have to read up more about Argentina. Out of curiosity, though, what would have happenned had they not gone with the dolllar? Were they only prolonging the inevitable?
posted by ph00dz at 6:59 PM on May 5, 2004
Out of curiosity, though, what would have happenned had they not gone with the dolllar?
Ah, that's the fun part of being a history major -- thinking about all the stuff that could have been. I think pegging pesos to dollars was decent idea, except nobody predicted the dollar would take off the way it did after the tech boom (well, I did, but I was not consulted). As soon as they realized they were screwing their exports, though, they should have cancelled it. The flexibility to adjust for the "real world" might have saved them from all the shit that went down. But again, who knows?
posted by Civil_Disobedient at 8:29 PM on May 6, 2004
Ah, that's the fun part of being a history major -- thinking about all the stuff that could have been. I think pegging pesos to dollars was decent idea, except nobody predicted the dollar would take off the way it did after the tech boom (well, I did, but I was not consulted). As soon as they realized they were screwing their exports, though, they should have cancelled it. The flexibility to adjust for the "real world" might have saved them from all the shit that went down. But again, who knows?
posted by Civil_Disobedient at 8:29 PM on May 6, 2004
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So basically you're putting your currency in the hands of a government you have no say in. While your economic conditions might require inflationary price controls but the US doesn't, your country loses out. It works okay for small coutnries like Panama but I don't know how it works for China. I didn't know they pegged their yuan on the US dollar. Though as the Chinese main export nation would be the US, there would be strong correlations.
posted by geoff. at 9:36 AM on May 5, 2004