Deciding to artificially support a currency is like jumping on the back of a tiger. Unless you are sure you know how to get off, prudence lies in never getting on.
The International Monetary Fund and finance ministers’ meetings in Dubai this past week moved a spotlight back on the efforts of Japan and China to keep their nations’ currencies cheap in terms of the U.S. dollar.
Many analysts focus on how weak yen and yuan policies affect the United States and the European Union as well as Japan and China themselves. Few address a more fundamental question. Can these nations stay on the back of the tiger? Can their dollar stabilization efforts succeed in the longer term?
Judging their prospects for success is beyond my expertise. The governments of Japan, China and the United States are not the only people, however, making such calculations. Hundreds of currency traders are making parallel calculations. The conclusions they reach will significantly affect what happens with Japan and China’s policies.
Understanding what speculators do is essential. They trade billions of dollars of different currencies for one another every day. Some trades are part of import or export deals. Others occur when an investor based in one country wants to invest in another. Many are executed by speculators who buy a currency at one price in the hope that they will make a profit by selling it later at a higher price.
Consider some speculator who is convinced that China will fail in keeping the dollar expensive. The prevailing exchange rate is about 8.27 yuan to one U.S. dollar. She takes $1 million and buys 8,278,100 yuan. If her judgment that the dollar is destined to get cheaper is correct and the exchange rate moves to 7.1 yuan to the dollar, a 15 percent decrease in the dollar’s yuan value, she will be able to change her 8.27 million yuan back into dollars and will have $1,176,471 — a tidy profit, indeed.
The annualized returns on her investment can be enormous. They also are highly risky. If the yuan value of the dollar moved up, however, our speculator would take sharp losses. But when a country climbs out on a limb the way China has, the possibility of further dollar strengthening is minimal.
Speculation has important effects on the success of currency interventions. If one speculator with $1 million buys yuan, the effects on China’s policy would be like a burp in the middle of Hurricane Isabel. If hundreds of speculators mobilize billions or tens of billions of dollars, however, the situation changes.
Remember that China is buying up “excess” dollars offered for yuan. If it did not, the value of the dollar would fall; that is, its price would fall to less than 8.27 yuan. When speculators think such buying is doomed to fail, they will jump in, offering even more dollars.
China’s central bank will end up chasing its own tail; the more dollars it buys up to maintain the dollar’s value, the more dollars speculators will offer for yuan in exchange markets, knowing that as Chinese dollar purchases rise, so do the chances of speculative profits. The dollar’s fall in value becomes pre-ordained in a vicious circle.
Historically, it is more common for other countries to try to keep the dollar cheap rather than expensive. Korea, Hong Kong, Indonesia, Thailand, Russia, Brazil and Argentina have all came to grief with such policies in the last six years.
When the object is to keep the dollar cheap, the game inevitably ends when the country runs out of dollars and can no longer hand them out to anyone who arrives with a handful of the domestic currency.
This doesn’t apply in the case of China and Japan. They can print money to buy dollars as long as they want. But taken to extreme, such efforts inevitably affect their domestic economies even more than revaluing would.
Note also that Japan and China are not in the same boat. Japan has been supporting the dollar, but has not announced a hard target for the yen/dollar rate. They can gradually diminish support for the yen without provoking a speculative feeding frenzy.
China, with its long announced and defended official rate, is in a much more difficult position. The closer it appears to come to revaluation, the more it will be inundated with speculative dollars offered by traders who want to be the last ones slipping in the door.
The ending may not be pretty.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.