US President Donald Trump was right to accuse China of manipulating its currency – before changing his mind.
The same charge, however, could have been levelled from anywhere in the world.
Whether directly or indirectly, every country manipulates its money to a certain degree. Even among the one in three countries with floating currencies, about half consistently intervene to create stronger or weaker exchange rates.
The US has a floating currency, which means that the value of the dollar changes daily in response to the supply and demand for the greenback around the world.
But the central bank can affect the exchange rate as well, albeit indirectly. The US dollar rises and falls on pronouncements from the Federal Reserve about interest rates.
What really matters is not the manipulation but if it has deleterious effects on the rest of the world. Today, there are no such effects from China. Here is why.
Price control scheme
In a fixed exchange-rate regime (known as a peg), a country determines the price of its local currency and, as needed, buys or sells foreign currency to maintain that price.
This is analogous to any price-control scheme. If a gallon of gasoline cost US$1, for example, the government would have to supply extra fuel if demand increased. Conversely, if gas were US$5 per gallon, and fewer people than expected were buying, the government would have to pick up the slack.
Fixed rates require a country to correct any mismatch between supply and demand.
Figure 1: Number of countries per exchange rate regime
|EXCHANGE RATE REGIME||NUMBER OF COUNTRIES|
|No separate legal tender||13|
|Other managed arrangements||18|
When market agents stop believing that the government will step in to keep prices stable, then we have what is called a speculative attack. Domestic and foreign investors start to sell off a country’s currency assets.
A “shadow” price is then estimated, in the absence of government intervention. A government can maintain a peg whose fixed exchange-rate is different from its shadow price only if it is able or willing to undergo massive interventions in the foreign-currency market.
An undervalued currency was the norm in China in the mid 2000s, when the People’s Bank of China (PBOC) set 8 yuan per US$1.
With a shadow price well below that exchange rate, the inflow and the outflow of foreign currency went out of whack.
An undervalued peg creates an artificially weak exchange rate; demand is higher for foreign currency. For American exports this is bad, as it inflates the costs of companies buying American goods. China rode an undervalued peg during the 1990s and 2000s, keeping exports relatively cheap and imports artificially expensive.
An overvalued peg, on the other hand, makes local currency stronger than it should be. Many Latin American countries, including, famously, Argentina, had an overvalued peg in the 1990s, and their export companies suffered.
The best and the easiest way to estimate the shadow price in the case of the evolving Chinese peg is through changes in the country’s foreign reserves.
When the peg was undervalued, the PBOC bought foreign currency to keep the yuan undervalued. This is how China accumulated its large foreign holdings of mainly American treasury and other government bonds.
Figure 2: Foreign Reserves of China (in USD trillion)
This all changed in mid-2014. A global recession and the fear of a hard landing by the Chinese economy shifted the peg from undervalued to overvalued.
In other words, the shadow price of the yuan was devalued. Because the PBOC kept the yuan peg relatively unchanged, the Chinese central bank had to start selling foreign currency to investors and companies that wanted to take their money out of the country.
Chinese reserves stood at about US$4 trillion in 2014, when capital started moving out of the country. This process accelerated in January 2015, a month after the US Federal Reserve increased its interest rate for the first time in almost a decade. Eventually, net outflows reached almost US$100 billion per month.
A slow burning speculative attack on the Chinese currency was underway. Faced with the assault, Chinese authorities had several options.
They could make capital controls tighter, impeding or even prohibiting different types of outflows; increase the interest rate to try to bring in more foreign capital; ride the crisis out, until its reserves were close to exhausted; or accede to the attack.
They chose the fourth option.
On two days in August 2015, the PBOC allowed the yuan to devalue by 3%, and it started a process of mini-devaluations until there were no more incentives for net capital outflows. In doing this, China slowly brought the fixed yuan closer to its shadow price.
In 2016, after the equivalent of US$1 trillion was spent on thwarting the speculative attack and keeping the volatility of the yuan low, the Chinese economy stabilised.
The fears of a crisis were averted. Investors stopped sending huge amounts of money abroad. Things came back to normal.
Capital outflows or inflows were minuscule, and confidence rebounded. Now, Chinese foreign holdings stand at around $US3 trillion.
A new normal
This is the new normal.
The yuan is much closer to a floating currency than ever. The main reason that the PBOC does not allow the currency to completely float is to keep a hold on volatility.
In the new normal, China continues to manipulate its currency, but without real economic effects on the rest of the world. The yuan is still subject to PBOC’s control, but its value does not impact world exporters negatively.
In the past, the cheap yuan boosted Chinese exporters at the expense of the world’s. Today, its price is fair. And it should continue to be fair, as Chinese authorities have learnt the lesson of trying to artificially prop its currency.
This could be a big step towards full liberalisation of capital movement.