I owe U.S. Treasury Secretary John Snow big time. I’m teaching international economics right now and the news his recent remarks in China generated gave me material for weeks.
For those who missed it, Snow went to Asia in late August. While in China, he appealed to that nation to float its currency in international foreign exchange markets and let it depreciate against the U.S. dollar.
Chinese officials were quick to state that their financial system is not ready for a free-floating currency and they are not going to change existing foreign exchange policies. Pundits and editorial writers have been arguing about who is right.
One may wonder what the hullabaloo is all about.
For 25 years following World War II, exchange rates for most nation’s currencies were fixed, and most were referenced to the U.S. dollar. That system largely ended in the early 1970s. The values of the currencies of most industrialized nations now float. But some nations, including China, continue to maintain an official or unofficial fixed rate for their currency relative to some other key currency.
Setting an official exchange rate isn’t the end of the matter. If China wants to maintain an official rate, it has to sell dollars at the official rate to anyone with yuan who wants them. Moreover, it has to buy dollars, using yuan, whenever anyone has dollars they don’t want.
Maintaining the fixed rate is easy — as long as the market is such that yuan offered for dollars at the official rate roughly matches dollars offered for yuan. Maintaining such a fixed rate becomes difficult, however, when there is a mismatch.
The most common problem is that a currency becomes overvalued when the official rate values the currency higher than the market does. If the currency is pegged to the dollar, the country’s central bank has to sell dollars to everyone with a handful of domestic currency that they want to exchange.
When the central bank runs out of dollars, as most eventually do, there is a foreign exchange crisis such as those in Asia, Brazil and Russia in 1997-1998 and repeatedly in Mexico over the last 25 years.
China’s problem is just the opposite. The yuan is undervalued compared to the rate that would prevail in a free market. So its central bank has to hand out yuan and buy dollars. Since it can create all the yuan it wants, there is no danger that it will “run out.” But buying up surplus dollars results in an unintentional loan to the U.S. Treasury and is hard to sustain over the long run.
The Chinese government has been buying dollars like crazy to keep it “strong” or expensive. Looking at the other side of the coin, it is keeping the yuan “weak” or inexpensive.
Estimates are that the Chinese have bought up some $80 billion in the last 18 months. The Chinese central bank puts many of these dollars into U.S. Treasury bills, though its decision to hold onto lots of dollars implicitly constitutes a loan to our country whether they buy such bonds or not.
Why would a capital-short developing country make huge loans to a capital-rich United States? The Chinese don’t want to do this, but they have to if they want to maintain a strong dollar/weak yuan situation. Why? Because a weak Chinese currency keeps Chinese products cheap for U.S. consumers.
If China increased the value of its currency by going to a higher, but still fixed, rate or if it simply let the yuan float, U.S. imports from China would drop substantially. The Chinese government does not want to face the economic and political consequences of such an export decline.
Snow’s critics argue that ending China’s artificial support of its currency would reduce its purchases of U.S. Treasury issues. That would push up U.S. interest rates. Moreover, they argue, a weaker yuan would hurt U.S. manufacturers based in China or U.S. companies such as Wal-Mart that import from China. Finally, higher-cost imports from China would contribute to higher inflation in the United States.
All this is true, but ignores the glaring fact that current levels of Chinese exports to the United States cannot be sustained forever. Similarly, the Bush administration’s federal deficits are not sustainable over the long term.
Exchange rate changes are how market economies respond to imbalanced trade flows. Higher interest rates signal that capital is becoming scarcer. China’s current dollar-buying spree suppresses these important market signals within both countries’ economies.
China is a sovereign state and ultimately will set its own policies regardless of U.S. pressure. Many western economists echo the concern that China’s financial system is not sophisticated enough to handle floating rates.
Push is coming to shove, however, and China will have to act sooner or later. A managed revaluation to a cheaper dollar is probably the best alternative.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.