Putting the Dollar on Steroids: Chinese Currency Intervention

by Joseph Cox

When China passed Japan to become the world’s second largest economy this summer, (i) the United States seemed resigned to its fate as a global also-ran. While China has only one-tenth of the U.S. GDP per capita, the U.S. unemployment rate (9.6%) hovers just below China’s GDP growth rate (10.3%), making the future of U.S. global leadership seem bleak. Not surprisingly, a plurality of U.S. respondents to a 2009 Pew Research poll named China the top economic power in the world (ii).  In reality, China’s rise is far from accomplished; the U.S. has more to gain, than fear, from a wealthy China. While Americans hold many misconceptions about Chinese policy – from debt to trade – the economic reality is more complex than it appears.

That China holds a massive amount of U.S. government debt has become a source of popular outrage for American politicians of every stripe. What is less well understood, is exactly why China keeps buying so much U.S. Debt. In fact, China must purchase U.S. Treasury bonds, even though it often takes a loss in the process. A complicated cycle has developed due to tight Chinese controls on currency outflows. Chinese exporters must convert the dollars they earn into Chinese renminbi, leaving the central government with dollars and the Chinese economy with freshly printed currency. To prevent inflation as the economy absorbs hundreds of billions of dollars worth of the new currency, the Chinese government sells domestic bonds to remove money from circulation, a process known as “sterilization”(iii).  Meanwhile, the dollars confiscated at the border are spent on the only good capable of absorbing that much money: U.S. Treasury bonds. The gap between the low rate of return on Treasury bonds, and the bond rate, in a fast growing and poor country like China often entails negative arbitrage, the difference between the rate of return on two investments, for the People’s Bank of China. To minimize their losses, China makes low rates on domestic bonds palatable by instituting price controls on necessities and banning certain types of speculative lending. This process has led China to accumulate foreign reserves amounting to almost 50% of GDP (iv) which is a staggering 4% of global GDP. This Rube Goldberg-style economic policy is not sustainable, but breaking it will involve a period of difficult transition to increased economic openness and increased Chinese domestic consumption as a component of GDP(v).

The current American obsession with China’s currency manipulation is tied to their tight control of the domestic currency. The simplest way for China to deal with massive imports of foreign capital from trade is to allow the renminbi to float with market prices. With all else equal, the value of currency should increase in net exporting countries and decrease in net importers (vi). Eventually, trade deficits will lead to currency depreciation, which will shrink the trade deficit because it makes exports relatively cheaper and imports relatively more expensive. The peg that prevents currency appreciation in China keeps Chinese exports competitive, but it has also incited increasingly inflammatory accusations of currency manipulation from Chinese trading partners(vii).

A “strong dollar” has a pleasant ring to it, but Chinese currency intervention renders many U.S. exports too expensive to be completive globally. An artificially strong dollar costs the U.S. jobs; one estimate is that the $226 billion dollar U.S. trade deficit with China has cost the U.S. almost three million jobs (viii).  The narrative that blames the Chinese for U.S. unemployment is more pleasant than the underlying truth of dollar depreciation: the only way to reemploy much of the country is by lowering real wages for American workers. Even though wages have stagnated in recent decades, a strong dollar, and the massive expansion of consumer debt, enabled American consumers to purchase cheap Chinese goods that raised the American standard of living. If China agreed to weaken its peg against the dollar, or if inflation reduced the value of the dollar, U.S. households would reap benefits from depreciation in real debt alongside real wages, and the devalued currency will increase exports and therefore growth resulting in increased employment of American workers (ix). Meanwhile, Chinese consumers have been partially left in the cold by currency intervention during this period of robust growth by a threadbare safety net and artificially depressed buying power.

In the long run it will benefit everyone for Chinese currency to reach market value, but the transition to a consumption fueled economy is tricky. The Japanese allowed the yen to appreciate in 1985 and shortly thereafter were rewarded with the “lost decade,” where Japanese currency appreciated so fast that it created a massive asset bubble that burst into a national financial crisis. China seems determined to avoid that fate; but the U.S. is similarly determined, and their respective goals may be mutually exclusive. The prolonged Japanese recession was marked by persistent deflation until the Bank of Japan publically committed to “maintaining low rates until inflation was reliably forecast to remain positive” (x). The Federal Reserve has cautiously begun to explore a similar commitment during the current financial crisis (xi). If the Fed prints more money it will simultaneously push down the value of the dollar and returns on Treasury bonds. China will suffer arbitrage losses on Treasury versus domestic bonds, while renminbi appreciation will cause export driven growth to slow. The Chinese may have the world’s second largest economy, but it is a distant second, only slightly more than one-third the size of the U.S. economy. If the Chinese informal currency peg remains in place, the contrived currency cycle and Chinese economy will be dragged down with the dollar.

China’s centralized government has proven capable of jealousy-inducing economic responsiveness, but going forward China will face daunting challenges in the transition to increased openness and domestic consumption- not to mention the difficulties posed by aging demographics and demands for increased individual autonomy. How China navigates these obstacles will determine the prosperity of not just China, but also the United States. The two have become increasingly intertwined such that their informal economic alliance has become perhaps the world’s most important. Fortunately, economics is not zero-sum: Chinese economic growth does not have to hurt the American economy. Even in the past decade, punctuated by trade deficits and currency manipulation, most Americans benefited from cheap Chinese production. A more balanced relationship between saving and consumption in China will lessen the trade gap between the U.S. and China and will spread those gains more evenly. Vigorous Chinese economic growth will be the engine of the world’s economy for years to come. In these dismal economic times that is reason for optimism, not fear.

i. Barboza, David. “China Passes Japan as the Second Largest Economy”The New York Times. August 15, 2010.

ii. “America’s Place in the World 2009” Conducted by Pew Research Center for People and the Press conducted in association with the Council on Foreign Relations.. http://people-press.org/report/569/americas-place-in-the-world

iii. Devine, Ethan. “The Japan Syndrome” Foreign Policy September 30, 2010.

iv. Chinese State Adminstration on Foreign Exchange. “Monthly Foreign Exchange Reserves”, June 2010

v. Devine.

vi. Bartlett, Bruce. “America’s Foreign Owned Debt” Forbes Magazine.March, 10, 2010

vii. Chan, Sewell. “I.M.F. Chief Steps into Dispute About China’s Currency Policy” The New York Times. October 7, 2010.

vii. Brown, Sharrod. “For Our China Trade Emergency, Dial Section 301”The New York Times. October 17, 2010.

ix. Yglesias, Matt. “Pearlstein on Wage Cuts.” Think Progress. October 13, 2010.

x. Posen, Adam. “The Realities and Relevance of Japan’s Great Recession: Neither Ran nor Roshomon.” STICERD Public Lecture, London School of Economics. May 24, 2010.

xi. Nohara, Yoshiaki and Harui, Ron. “Dollar Trades Near 15-Year Low Against Yen on Speculation Fed to Ease More” Bloomberg Online. October 18, 2010.

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