Monday, January 26, 2009

Geithner very wrong re China's "currency manipulation"


In Tim Geithner's written responses to questions from the Senate Finance Committee that recently approved his nomination to be our next Treasury Secretary, he says that President Obama "believes that China is manipulating its currency."

I would agree with him that China has been "manipulating" its currency, but only in the sense that the rate of exchange between the yuan and the U.S. dollar has been far more stable than if it had been left to the vagaries of the market. I would hasten to add, however, that most of those who accuse China of "manipulating" its currency also believe that the Chinese currency should be far stronger against the dollar than it currently is (and, by inference, the U.S. dollar should be far weaker). I take great exception with anyone, especially our Treasury Secretary, who believes the U.S. dollar should be weaker against any currency. A strong currency is always in every nation's best interest, because it provides the bedrock for confidence, investment, and progress. Geithner is starting off on the wrong foot.

In any event, as this chart shows, the Chinese yuan has been strengthening against the dollar for the past 14 years. What more do weak-dollar advocates want? The Chinese are guilty of "manipulating" their currency only to extent that they have sought to slow the pace of its appreciation vis a vis the dollar. But is that "manipulation" in the sense of doing something wrong? No.

According to the teachings of international finance, a country can manage its currency in only one of three possible ways: by targeting an interest rate (typically the overnight lending rate); by targeting the quantity of money in circulation (e.g., Volcker's targeting of M2); or by targeting its exchange rate vis a vis another currency or basket of currencies. When you target one monetary variable, the others find their own level and the economy adjusts. The Chinese economy has had plenty of time to adjust to its currency target.

Since 1994, the Chinese have targeted the exchange rate of the yuan vis a vis the dollar. They have done this by buying up most of the capital inflows (call them dollars) that were seeking to enter the red-hot Chinese economy. If they hadn't bought the excess dollars seeking to purchase yuan and yuan assets, the yuan would have appreciated much faster. This is perfectly acceptable; by purchasing the excess of dollars (a trillion or so), the Chinese central bank created new currency, which was then absorbed by an economy growing in excess of 10% per year. And by amassing a huge pile of foreign reserves in the proces, the Chinese central bank has given the yuan rock-solid status, and that is a boon to the Chinese economy because it guarantees that investments in China won't be wiped out by a devaluation. A strong Chinese economy that can sell us cheap and quality goods is a win-win for everyone.

Geithner was confirmed with haste, and his sins were overlooked, all in the name of responding quickly to the current economic crisis. That sounds a lot like what the Obama administration is trying to do with the stimulus package. These are ill-considered moves, wrapped in the cloth of urgency, which are more likely to result in a permanent expansion of government than a quick resolution to our problems.

And this is one more reason why our stock and corporate bond markets are so depressed.

5 comments:

prophets said...

you aren't looking at it from an interest rate arbitrage standpoint.

if you fix one currency to another, you effectively adopt their monetary policy. when the US Fed slashes interest rates, it effectively hits the chinese economy. Otherwise when PBOC is running rates at 6% and the US Fed is at ~0%, money will flood into the 6% opportunity and the currency will not adjust to compensate for it.

the Yuan is materially overvalued, and the chinese economy is severely imbalanced.

Brian said...

"...more likely to result in a permanent expansion of government than a quick resolution to our problems."

Hmmmm. You might be on to something...

Could this all be political?

Scott Grannis said...

prophets: if China offered 6% risk-free interest rates and fixed the yuan to the dollar, they would indeed have a problem, but that's not the case. Rates in China are not materially different from those in the U.S. Plus, while the PBOC is clearly managing the yuan in relation to the dollar, it is not absolutely fixed.

With 14 years of the current exchange rate regime, the economy has had plenty of time to adjust to the currency. Economic growth has slowed, but it will still be at least 6-7% this year. And with over a trillion dollars of reserves, the yuan is not at risk of collapse. Therefore I don't agree that the economy is severely imbalanced.

Scott Grannis said...

Brian: what you suggest, that politics might have something to do with all this, is ... shocking! I'm shocked, shocked!

AG said...

Dear Reader,
At this link you can find an article on this topic
http://ssrn.com/abstract=1332842
The article takes a somewhat different take to China's currency accumulation, analyzing it in light of notions regarding usury and miserliness. If you read it and have comments, please contact the author using the link above.
Regards