What is China doing wrong with its currency?

I started this as a GQ but I think it belongs here.

Can someone please explain the details of the accusation that China is undervaluing its currency?

I understand the basic arithmetic. The value of the Yuan is keep low against the US dollar or Euro or whatever which means that Chinese exporters don’t need to charge as many dollars to get the number of Yuan they need to cover their costs and make a profit. I assume the Chinese government sets the exchange rate so it’s effectively telling their exporters “if you bring in X dollars then we’ll give you Y Yuan”. The US believes they should give less Yuan for the X dollars so they’ll need to charge more dollars therefore making their goods less competitive.

That makes sense but I don’t really understand the deeper issue. At the end of the day, isn’t China “simply” a (very large) group of people saying to the world “here’s what we make and this is the asking price in US dollars. Take it or leave it”. How they manage things internally seems like nobody else’s business.

I would have thought that the real question is: How do Chinese manufacturers manage to make and export things so cheaply compared to those in other countries? There might be some good reasons like efficiency, economy of scale etc and bad reasons like poor labor and environmental laws etc. I can understand how those things affect the prices but I don’t really see how the exchange rate puts them at an “unfair advantage”.

It’s on the side of Chinese imports that people get upset about the exchange rate. If the yuan is undervalued, it makes foreign products more expensive, and more difficult to sell. It is, effectively, a tariff on imported goods. The people who really get screwed are the Chinese, who can’t buy what they “should” be able to buy if the currency was allowed to float.

It goes beyond that. There’s a general macroeconomic understanding that the undervaluation also creates huge inflationary pressure inside China itself.

You can see this reflected in the price the average Chinese citizen pays for food and other goods. Because China encourages exports through its currency, there’s a danger of high inflation.

China has tried other measures to reduce inflationary pressure, but the easiest way to fight it is to allow your current to appreciate. But allowing the currency to appreciate means business interests are affected, since exports are no longer as competitive. They’ve also artificially held interest rates on bank accounts low. Also, some price controls have been implemented.

Unfortunately, these types of policies generally don’t work. Look at Iran and other Middle Eastern countries and their price controls on the price of gasoline. Inflation still continued and Iran has recently pretty much given up on price control of gasoline.

So, it’s not just a matter of China’s currency policy being bad for the US and the world. It’s actually a bad thing for the average Chinese citizen as well. But it’s a good thing for the elements of Chinese society who own and control large businesses. Guess who’s actually calling the shots?

Yeah, that’s pretty much it as the first step. But there’s another, less nice force at work.

It becomes other people’s business when China is deliberately using a “beggar-thy-neighbor” policy, decreasing the prosperity of other countries to increase their own.

As Great Antibob says, undervaluing your currency creates inflationary pressure. The currency is too weak, which means it can’t buy as much as it should. Inflation is starting to get out of hand in China. What’s the Chinese response? To increase interest rates. But that means China is decreasing world demand. They’re decreasing demand at a time when the world is already suffering insufficient demand. Not too friendly, there. Compare this with the US QE2. The US monetary actions have decreased the strength of the dollar, sort of, if you’re keeping in mind that the dollar is finally back to roughly where it was before the recession started on the foreign exchange markets. But at the same time, the purpose of QE2 is to increase demand. We’re not actually trying to profit at the expense of others.

They make stuff cheap because they’re extremely poor, so their labor doesn’t cost much. That’s pretty much it, the prime driver of the thing. Their country is so big that even when the coasts industrialize and get richer, they still have an enormously large supply of grindingly poor people in the interior who can still move to the factories to work cheap. Lax environmental rules are also a reason for low production costs, but it starts with their poverty.

John, that brings up an interesting point with regard to arbitrage that I’ve been wondering about. In discussions in the past about the social utility of the financial markets, arbitrage was pointed to as an example of financial markets serving a greater good even as investors sought only to make money for themselves. The idea presented was that if some tin-pot dictator wants to set the value of his currency at some arbitrary level by fiat, arbitragers would buy or sell that currency at other levels, figuring that they would make money on the deal, forcing the dictator to move toward a more reasonable price or lose beaucoups of bucks.

To give a concrete example, say Chin Ho Fat of the Amalgamated People’s Republic of Fredonia says Freedobucks are worth 50 cents to the dollar and that’s the only rate they’ll accept. But the geneal feeling among currency traders is that if the exchange rate were actually allowed to be traded freely, Freedobucks with be worth 75 cents to the US dollar. So what happens? The currency speculators buy Freedobucks at the given exxchange rate and then trade them for other currencies based on their feeligns about the value. Which means that if Chin Ho Fat wants to buy US dollars he has to pay at the higher rate. Soon he goes broke.

In this way, currency speculators keep governments from artificially inflating or deflating their currencies, is the way I have heard defenders of arbitrage call it.

but that is not happening to China. Why is that not happening, John?

Well, I’m no expert on arbitrage, but my first thought is that your example works only for small countries where arbitrageurs can buy up a significant amount of the currency to affect its price. China, being the 2nd largest economy in the world would present a problem of scale for the would-be arbitrageurs.

Secondly, I would assume that the arbitrage would have to take place over a relatively short period of time, else the risk is too high. No one knows when China is going to allow its currency to float to its natural level. They set the price, in US dollars, once per day, and it doesn’t vary all that much.

But I could be completely wrong. I’ll let someone more knowledgeable take a shot at answering, although I’m confident that you haven’t stumbled on some actual gold mine. :slight_smile:

So the Chinese have a policy that’s both inflationary and decreasing demand? Maybe you need to think this through a bit more.

It would be nice if I had stumbled on a gold mine, but what I actually think I have found is a response to the argument that arbitrageurs have social utility, and are not just parasites on our economy, making huge amounts of paper money without actually producing anything useful. The argument has always been that arbitrageurs keep governments honest by preventing them from controlling their currency’s value by fiat, as China has clearly been able to do for some time now. Arbitrageurs have been able to do nothing against the grossly undervalued Chinese currency. So they have little or no social utility and are in fact economic parasites.

No, you haven’t shown that at all. All you have shown is that currency arbitrageurs have not been able to achieve, in this one instance, some goal that you think is desirable. At any rate, I don’t think either of us knows enough about currency arbitrage to have a meaningful debate on the subject.

Maybe not meaningful, but illuminating. I well remember the arguments about arbitrage on this board, and that was the response: arbitragers had social utility because they prevented governments from overvaluing or undervaluing currency by fiat: arbirtragers were supposed to be able to prevent that by speculating against the over or under valued currency. Perhaps I will start the argument in a new thread and see if we have any arbitrage whizzes on hand who can straighten me out on this point in specific terms.

Good idea.

Again, I am no arbitrage expert, but usually arbitrage is about buying something in one market and then selling it, usually immediately, in another market where it is worth more.

Perhaps what you are thinking about is currency speculation. You buy currency X thinking it will be worth more at a later time, then when that time comes you sell it. If enough speculators are available, they can drive the up the value of that currency by creating “artificial demand”. But again, you have to be able control a significant amount of the currency to do that, and with the yuan, that would be almost impossible to do given the size of China’s economy.

They’re also favoring poor workers over middle-class consumers, presumably because they have more of the former than the latter, and don’t want them to become restive. If the currency was allowed to float, a lot of Chinese manufacturing would become uncompetitive versus even poorer countries, like Vietnam.

Two ways. One is that they have a very large pool of very cheap labor. That gives them an edge in assembly type manufacturing, since it drops their labor rates compared to other countries. The other is that, by devaluing their currency to ‘unnatural’ levels it makes their products more base line costs less (while making any imports coming into China naturally cost more). Well…there are more than two, really. Another reason is that, while they have plenty of regulations on the books for things like work environment and environmental protection stuff, they are rather selective in how they enforce those regulations.

Of course, as others have pointed out, this is a double edged sword for the Chinese. To maintain it they have to pump large amounts of what they make back into other countries currencies (like the US and Europe). It causes quite a bit of local inflation, and it keeps their large pool of poor labor, well, poor, while keeping the prices of goods and services high and getting higher. Eventually they will be forced to modify this or they will hit a wall (or other countries will start taking punitive actions against them…or some combination of all of those plus a few more Bad Things™ will happen).

The Chinese, supposedly folks who take the long view on everything are basically trading short term benefit and growth for medium and long term problems. I think they if they run fast enough they will outrun their problems, or something else will happen to mitigate them. That’s all well and good, except that if you stumble it’s easier to regain your balance or not hurt yourself as much if you aren’t running flat out.


I’m not fully convinced by the whole ‘China’s yuan is undervalued’ argument. China ended the dollar peg more than 5 years ago, and only introduced a soft peg in the wake of the financial crisis, which I think is a *good *thing: during times of financial distress, certainty is almost always a good thing. China removed the soft peg last year, and the yuan has continued its general appreciation ever since. Reading some media reports you almost get the impression that the yuan has been plummeting in value day by day, when in fact it’s been mostly strengthening for years.

In other words: China is doing what US exporters want it to do, only not quite fast enough to please them. Can I get a ‘waaah’ please.

Secondly, while US exporters will benefit from a stronger yuan, US consumers clearly benefit from a weaker yuan.

I’m hardly a Sinologist or apologist for China, but this whole ‘yuan undervalued’ debate is much ado about nothing to me. To anyone that things the yuan is undervalued, I ask you: So what rate should it be at vs the dollar, the euro, the yen, the pound, etc?

Let’s take a look at what I actually wrote:

Underlined emphasis added. China is deliberately undervaluing its currency with its managed exchange rate. This is inflationary. As a response to the inflation, China has increased interest rates. This is contractionary, decreasing demand.*

These are, it can be seen, two different policies. It is possible for a country to pursue two different policies at the same, even if the two policies have contradictory results. As Paul Krugman points out, “China can separate exchange rate policy from domestic monetary policy because it has capital controls.” This is in the same sense that I can open the windows outside, and also turn up the heat. Turning up the heat increases the temperature. This is true even though I’ve got the windows open to let in the cool winter air. China increasing interest rates is contractionary, decreasing demand. This is true even though their undervalued currency is inflationary. The whole reason why China increased interest rates to decrease demand is precisely because their exchange rate policy is too inflationary.

One might think that I should just close the windows, instead of turning the heat up. One might think China should allow its currency to appreciate more quickly, instead of increasing interest rates. But this topic is a bit tricky, as you have so well demonstrated with your question. There are underlying political reasons why they’re doing what they’re doing. China’s social stability depends largely on their economic performance. It’s a difficult balancing act.

*This increase in rates has actually been more limited than it might have been. There are seemingly strong political forces against high interest rates, just as there are against a rapidly appreciating currency. So rates have gone up a bit, but not enough to curtail inflation.

This advice is so good that I’m going to recommend you learn to follow it yourself.

If it were properly valued, they wouldn’t be suffering this recent spike in inflation.

I agree entirely, though, about the pointlessness of the whining. We have other things we should be doing.

I’ve heard that this is ceasing to be the case actually. Up until now the workers fueling the Chinese boom were largely born before the one-child policy was introduced in 1978, and most of them have already moved to cities to work in factories (remember that plenty still need to be in the countryside to run the still unmodernized agriculture). Obviously since the one-child policy reproduction has been lower than the level needed for replacement, so the cheap supply of labour is beginning to dry up.

The evidence for this can already be seen in Chinese workers attempts to gain improved pay and working conditions. While this is partly due to China’s increased wealth it is also made possible by increasing demand for labour. 10 years ago it could not have happened as any complaining workers would have been instantly replaced by new immigrants from the countryside.

I am not an economist, but isn’t one result of buying lots of U.S. debt that it strengthens Dollar against the Yuan?

Hmmm…cite? In case you haven’t noticed, other countries are also seeing stronger inflationary pressures regardless of currency: food inflation (expect ‘agflation’ to be a big buzzword this year) is usually pointed to as the main culprit. For example, the Food and Agriculture Organiztion (a UN body) announced just a couple of weeks ago that its food price index for December hit a record high, beating the previous highs in 2008.

Theoretically, I suppose. But the forex market sees trillions of dollars worth of transactions daily. I kinda doubt a few billion dollars a month of countries buying US T-bonds would have that significant of impact. Besides, the dollar has been broadly weaker for the last six-eight months or so, including hitting a two-month low last Friday.

Even if China swaps yuan for dollars, then uses those dollars to buy US debt, at some point they either have to convert those dollars back to yuan (which would partially offset the impact of dollar buying), or they will use those dollars gained from maturing T-bonds to either buy more t-bonds (in which case there is no impact on the yuan/dollar rate) or they invest in other assets in the US (stocks, bonds, corporations etc), which would probably be viewed as a good thing (and would have no impact on the yuan/dollar rate). The fact that we have a trade deficit (i.e., current account deficit) exactly means we have a capital account surplus (i.e., we’re borrowing from foreigners, or foreigners are buying our assets). Some negatives notwithstanding, overall this is generally a good thing: It means the US is perceived to have strong growth prospects and a very competitive global economy.

Besides, Japan holds almost as much federal securities as China (end-November 2010: China $895.6bn, Japan $877.2bn) and I don’t hear anyone raising a fuss about it. As of end-September 2010, almost 60% of US debt was owned by…the US (US individuals, US institutions, and the Social Security Trust Fund). Does the Fed really care who is buying t-bonds? If someone is buying them, it simply means China and Japan is helping us fund our stimulus efforts, no?

I’ve never really understood the moral outrage behind this issue. China seems to have found an economic policy that works well for them. Don’t all countries basically do what is in their best interests? Why should China tailor it’s economic policy to our needs?

As John pointed out, arbitrage is buying of a commodity in one market and selling it in another to make a profit. The social utility of this is to help prices for those goods to converge so that they cost the same wherever you buy them.

I don’t think it really has much to do with China fixing it’s currency agenst the dollar.

Well, the practical reason is that we are a trading partner with China. As trading partners, both countries are certainly looking out for their best interests, however, ideally one wants to negotiate a deal that provides the greatest mutual benefit.