Hi,
I understand governments spend their own currency/ buying dollars on the open currency markets (forex markets), what is commonly called currency intervention/currency manipulation but how exactly does it work?
I look forward to your feedback.
davidmich
Like stocks or any other financial asset different people have different ideas on what each is worth. As more and more units are sold, you must attract into the market people who have lower and lower valuations because those with higher valuations have already purchased.
Similarly when a country is buying dollars with their own currency, you can just as well say they are selling their currency for dollars. This drives the world market price of their currency down.
The reason this is usually down is to make their exports cheaper for other countries to buy which lets production in their country increase.
Japan in the 70s and 80s artificially kept the Yen low against the US$ to their obvious advantage since they export to the US. Aside from market forces as mentioned above, the exchange rate against the US$ was derived by looking at the difference between the two countries’ respective interest and inflation rates. Japanese economic managers tweaked those two variable (among others) to keep the Yen low.
There are 2 mechanisms. The less important is selling domestic currency (and buying foreign currency), because the size of the foreign exchange market tends to overwhelm the size of the central bank - though the latter is the largest player.
The more important mechanism is to manipulate interest rates so as to strengthen or weaken the currency. And that’s something central banks can do. Raising rates tends to strengthen the currency, as investors rush in to get better returns. Lowering interest rates tends to weaken the currency, as investors flee so as to get better returns.
When speculators conjecture about future moves by the central bank, the preceding effects can be intensified.
The tricky part is that manipulating interest rates and exchange rates also has an effect on the economy (which in turn has effects on interest rates and exchange rates).
And exchange rate manipulation is the supposed way that the Chinese government is keeping Chinese exports cheap for the rest of us. In a non-manipulative environment, trade imbalances tend to be self-correcting toward an equilibrium, with occasional swings one way that correct themselves over time back toward equilibrium. So if the US is importing lots and lots of Ruritanian blankets and not selling much to Ruritania, then the US dollar will fall against the Ruritanian Gelgamek (RUG) as money flows into Ruritania and more people want RUG than USD. After a while, the USD will get so cheap compared to the RUG that US made Chevys will be so cheap to Ruritanians that they will start falling over each other trying to buy one, and the people (or importers) will clamor to convert their RUGs to USD to buy Chevys. The USD then appreciates as a result.
Supposedly the PRC has been manipulating inflation by selling craploads of newly printed money to people bringing other currencies in. If they stop this, then supposedly Chinese stuff will start getting more expensive, the US will import less from China, and China will start buying more of our stuff because of how cheap it was becoming. Sure, Chinese stuff will probably stay cheap overall when compared, to, say, German or Swiss made stuff, but the gaps will start to close and it will become feasible again to make stuff in Newark, NJ and ship it to NYC rather than make stuff in Beijing and ship it all the way across the Pacific to LA, then all the way across the continent to NYC.
That’s a plausible story under currency controls. If exchange rates float, then prosperity in Ruritania leads to a stronger currency as foreign investors clamor to invest in RuriRugs Inc and other businesses. This exchange rate appreciation in turn will tend to hurt Ruritan’s exports.
In practice, there’s a lot of over-shooting in exchange rates - they are rarely within a couple of percentage points of purchasing power parity. It’s a messy market.
The PRC’s main mechanism is the purchase of US treasuries. Chinese-made products sold in the US get paid for in US Dollars which eventually make it to China where they need to be converted to Yuan. Normally that exchange would happen on the open currency markets and the USD would end up in the hands of people who want to spend USD, lowering the USD’s value. But instead the central bank buys them up (with aforementioned new Yuan) and uses them to buy up US treasuries, which prevents those dollars from getting back to the open market where they might decrease the value of the dollar and therefore China’s competitive advantage.
So basically, China buys a fuckton of American debt, not as any kind of investment, or even political leverage, but just to buy some short-term economic growth.
Note that the practice makes imported goods astronomically expensive in China, which is why Western countries don’t simply follow suit.
Except this is not to the obvious advantage of the Japanese people. It means they are selling the goods they export at a discount, and pay a premium for goods they import.
If you were making goods and selling them, why would you want to sell at a discount? If you were buying goods, why would you want to pay extra? You wouldn’t–you’d want to buy low and sell high. Exchange rate manipulation of this sort means you buy high and sell low.
The justification for this is that it protects your domestic manufacturing from competition. They don’t have to compete on a world market because foreign goods are kept out, and domestic consumers have no choice but to buy domestic goods. This is great for domestic manufacturers and terrible for domestic consumers. But who cares about the consumers? Countries generally set their industrial policy for the benefit of the wealthy and connected industrialists and exporters, and at the expense of the workers and consumers.
China’s central bank, like all central banks, issues money. They don’t just spend it willy-nilly, though, they buy assets. For example, dollars, and dollar denominated securities. As of 2011, according to this article, they had purchased $3.2 trillion in cash alone. I don’t know how much of that is dollars, or how much more they’ve got in securities (at least another $3 trillion or so, if memory serves), and finding good info on the PBC’s balance sheet is hard, for me, at least.
Anyway, the point being, they’re flooding the international market with renminbi, which (1) according to the law of supply and demand, pushes down the value of Chinese currency relative to other currencies, and (2) creates a huge demand for Chinese products. The Chinese, obviously, think this is a good policy for them. And maybe it is. Who am I to question the wisdom of Chinese central bankers?
But the practical result is a huge outflow of real wealth, in the form of Chinese goods and services, to the rest of the world, especially the US, in exchange for mere financial wealth, in the form of US dollars.
It seems like a poor trade to me.
They’d be better off financing that flow of goods and services to Chinese people, instead of to Americans, if you ask me.
Well, I think they’re doing it to create jobs. And jobs are good things.
But I’d argue, unless you have a special need for dollars (and that’s entirely possible, in some circumstances) you’d be better off buying your own currency, rather than someone else’s.
Edited to add: obviously, you can’t buy your own currency, literally. What I should have said: they’d be better off buying their own country’s sovereign debt. And of course, Japan is now doing that.
Thanks leahcim. That’s what I was trying to figure out.
davidmich
Of course not. Value is value, whether in Yen or Dollars. The only thing is you’re measuring your earnings in Yen so you want a stronger foreign currency as your top-line (revenue) generator. That way, the incremental weakness of the Yen will give a bigger profit margin. You’re right about importation. You want a stronger Yen for that. What I meant was a weaker Yen is good for a net exporter to the US, which is what Japan used to be.
And Japan has always been an open market (at least on paper.) They did not hesitate to let companies like Caterpillar and Procter and Gamble into the local market. That’s to let companies like Komatsu and Kao get a taste of real competition.
I just want to point out a few obvious things to highlight the complexity involved. The forex markets are vast so while central banks can and do move them from hour to hour or day to day, over longer terms, this is difficult, even for big central banks like the fed.
Beyond that, generally speaking, interest rates are the price of money and so reflect supply and demand - in addition to other factors like inflation risk. Increasing supply acts very much like devaluing a currency since interest payments mean more of the currency has to be paid in interest to purchase the same amount of goods and services. Sometimes, like where you have deflation, that might be desirable, but generally it’s not.
So in a situation where much of a country’s debt is held by foreign investors, increasing the supply of currency can result in a drop in the value of the currency and a concomitant increase in interest rates unless there are countervailing factors - as there happen to be with the USD. And increases in interest rates tend to suppress economic growth.
This seems like a decent time to bring up the monetary trilemma. Policy makers get to choose 2 of the following: they can’t have all 3:
[ul]
[li] A fixed exchange rate.[/li] [li] Free capital movement (absence of capital controls).[/li] [li] An independent monetary policy. [/ul][/li]
You can weaken the currency and set interest rates wherever you want if you have strong capital controls. You can have free capital movement and a pegged interest rate - but then you have to let interest rates fluctuate - raising them to defend your currency and lowering them when you want it to weaken. etc.
What do you mean by a pegged interest rate. If you mean something like the fed funds rate, even that’s effectively a negotiated rate influenced by market factors.