Editor's note: This is how Dave's excellent post is supposed to look, I think:
Over the last several years, China has taken a lot of political heat from the US because it has intervened in the foreign exchange market to keep the value of the yuan at around 8 to the USD. To the extent that the yuan is more valuable relative to the USD, Chinese imports are cheaper, and US exports more expensive, which would increase the US trade deficit with China. Lindsey Graham and Charles Shumer introduced a bill in the Senate that would place a 27.5% tariff on Chinese imports so as to offset the perceived advantage of keeping the yuan’s value artificially low. (see http://www.senate.gov/~lgraham/index.cfm?mode=presspage&id=231718 for the political arguments). WTO action against China has also been threatened.
A quick lesson: Given that the US is much richer (on a per capita basis), the US will likely buy more goods/services from China than they will buy from US, which will of course generate a trade deficit. These trade flows generate a relatively high demand for yuan so as to buy the Chinese imports. Under ordinary circumstance, this high demand for yuan would tend to cause it to gain in value against the USD. This in turn would tend to make Chinese imports more expensive and US exports to China cheaper. The appreciation of the yuan would reduce the trade deficit. To prevent the yuan from increasing in value, the Chinese central bank sells yuan and buys USD in the foreign exchange market, which, the argument goes, contributes to the giant US trade deficit with China.
Note that I said above that any appreciation of the yuan would “reduce” the trade deficit with China. Because the U.S. is so much richer than China, and there are so many of us (nearly 300,000,000), we can afford to buy a lot of stuff from them. They can’t afford to buy as much from us, even though there a lot more Chinese. Thus, it is not surprising at all that we run a trade deficit with China. As an aside, this same argument applies to Japan: Even though on a per capita basis, Japan is about as rich as the U.S., there are only about half as many Japanese as there are Americans, and a persistent trade deficit with Japan is to be expected, regardless of currency values. Note that China itself runs trade deficits with both Japan and Germany.
Since last summer, China has allowed the yuan to appreciate a few percentage points against the USD. This slow depreciation is likely to continue. China ’s actions have not been viewed as fast enough, however.
Sudden changes in a currency’s value have a history of very negative side effects (Mexico, Argentina, and Thailand are some of the best recent examples). Granted these examples are of quick depreciation, and occurred against a backdrop of economic problems. China’s currency would rapidly appreciate, and its economy is very strong (maybe too much so—more in a minute on that). But, based on past history, China would be foolish to risk negative side effects of a rapid appreciation. They’ve also been rather closed mouthed about their future plans regarding the yuan—and for good reason. If they announced that they were allowing the yuan to rise against the USD, rational expectations on the part of currency traders would cause exactly this outcome, but the timing and amount of the appreciation may be outside the control of the Chinese and be too rapid and too much for their economy to handle. So, they’ve done the optimal thing: Don’t say anything, and just let the yuan adjust a little at a time. This will continue, along with the loosening of various capital flow restrictions, because China is very eager to be seen as a full-fledged member of the world trading community.
None of the above should be interpreted as favoring Chinese intervention in the foreign exchange market. Indeed, it may have been better to have never targeted the yuan in the first place. The point that I made above is that given that the Chinese have targeted the yuan (and imposed various capital controls), they are getting rid of those things in the right way. As it currently stands, China’s economy is in a very risky place, despite (or maybe because of) very high economic growth rates. Why is this? When China pegs its currency against the USD (which is in a mystery basket of currencies that the Chinese central bank actually targets), it effectively adopts US monetary policy. Consider the period from 2001 to 2004, when the Fed was busy reducing interest rates. Lower interest rates in the US would tend to appreciate the yuan. To prevent this, the Chinese central bank needs to sell even more yuan and buy more USD. When a central bank sells its own currency, it increases the money supply—an expansionary policy. With the Chinese economy growing at over 10%/year, this may be the wrong policy. But, it’s what happens when currency values are pegged. So, what have the Chinese done to try to slow down the economy? Lots of things, from having bureaucrats tell China’s banks to reduce lending; to raising reserve requirements of banks (this would also work to reduce bank lending). It is important to note that a lot of China’s growth is driven by government bureaucrats, not by allocation of resources by markets. If this growth is suddenly curtailed, and China’s shaky financial system becomes even more unstable (bad loans are a big problem), then there could be a severe contraction of the Chinese economy. One way or another, the yuan will likely gain value over time. Slowly, though, is better than quickly.
And one last thing: China is (or will be soon) the largest holder of US financial assets. How is this possible? Remember that the Chinese central bank is buying USD. It uses these to buy US financial assets, mainly US Treasuries. This fact has also caused political stresses with the US. The concern is that the Chinese could use these large holdings of US assets as leverage (i.e. threaten to sell them). This is unlikely, since it would result in a kind of financial mutually assured destruction. There is a risk, however, that severe economic problems in China could force them to sell US assets to survive the crisis. To the extent that such a mass sale damaged the US economy, the Chinese economy would also be further injured.