China’s exchange rate conundrum
By Ronald McKinnon
In late February, the slow appreciation of China’s currency was interrupted by a discrete depreciation from 6.06 to 6.12 yuan per dollar. Despite making front page headlines in the Western financial press, this 1% depreciation was too small to significantly affect trade in goods and services—and hardly anything compared to how floating exchange rates change among other currencies. Why then the great furor? And what should China’s foreign exchange policy be?
Foreign governments and influential pundits continually pressure China to appreciate the yuan in the mistaken belief that China’s large trade—read: saving—surplus would decline. This pressure is often called China bashing. And since July 2008 when the exchange rate was 8.28 yuan/dollar (and had been held constant for 10 years), the People’s Bank of China has more or less complied. So even the small depreciation was upsetting to foreign China bashers.
But an unintended consequence of sporadically appreciating the yuan, even by very small amounts, is (was) to increase the flow of “hot” money into China. With US short-term interest rates near zero, and the “natural” rate of interbank interest rate in the more robustly growing Chinese economy closer to 4%, an expected rate of yuan appreciation of just 3% leads to an “effective” interest rate differential of 7%. This profit margin is more than enough to excite the interest of carry traders: speculators who borrow in dollars, and try to circumvent the China’s exchange controls on financial inflows, to buy yuan assets. True, the 4% interest differential alone is enough to bring hot money into China (and into other emerging markets). But the monetary control problem is more acute when foreign economists and politicians complain that the Chinese currency is undervalued and the source of China’s current account surplus.
However, China’s current account surplus with the United States does not indicate that the yuan is undervalued. Rather the trade imbalance reflects a big surplus of saving over investment in China, and a bigger saving deficiency—as manifest in the ongoing fiscal deficit—in the United States. Indeed, the best index for tradable goods prices in China, the WPI, has been falling at about 1.5% per year—as if the yuan were slightly overvalued.
Although movements in exchange rates are not helpful in correcting net trade (saving) imbalances between highly open economies, they can worsen hot money flows. Thus, to minimize hot money flows, the People’s Bank of China (PBC) should simply stabilize the central rate at whatever it is today, say 6.1 yuan per dollar, to dampen the expectation of future appreciation. Upsetting the speculators by introducing more uncertainty into the exchange system, as with the temporary mini devaluation of the yuan in late February, is a distant second-best strategy for China to minimize inflows of hot money.
In addition, there is a second, less well recognized argument for keeping the yuan-dollar rate stable. In a rapidly growing economy like China’s with large gains in labor productivity, wage levels become quite flexible because wage growth is so high. That is, if wages grow at 15% instead of 10% per year (roughly the range of wage growth in China in recent years), the wage level moves up much faster. But wage growth better reflects productivity gains if the yuan/dollar rate is kept stable. If an employer (particularly in an export industry) fears future yuan appreciation, he will hesitate to increase workers’ pay by the full increase in their productivity. Otherwise, the firm could go bankrupt if the yuan did appreciate.
Thus, to better balance international competitiveness by having Chinese unit labor costs approach those in the mature industrial economies, China should encourage higher wage growth by keeping the yuan-dollar rate stable and so take away the threat of future appreciation. Notice that in the mature, not to say stagnant, industrial economies, macroeconomists typically assume that wages are inflexible or “sticky”. They then advocate flexible exchange rates to overcome wage stickiness. But for high-growth China, flexible wages become the appropriate adjusting variable if the exchange rate is stable. Unlike exchange appreciation, wages can grow quickly without attracting unwanted hot money inflows.
China’s State Administration of Foreign Exchange (SAFE) has now accumulated over $4 trillion in exchange reserves because of continual intervention to buy dollars by the PBC. This stock of “reserves” is far in excess of any possible Chinese emergency need for international money, i.e., dollars. In addition, the act of intervention itself often threatens to undermine the PBC’s monetary control. When it buys dollars with yuan, the supply of base money in China’s domestic banking system expands and threatens price inflation or bubbles in asset prices such as real property.
Thus to sterilize the domestic excess monetary liquidity from foreign exchange interventions, the PBC frequently sells central bank bonds to the commercial banks—or raises the required reserves that the commercial banks must hold with the central bank—in order to dampen domestic credit expansion. Both sterilization techniques undermine the efficiency of the commercial banks’ important role as financial intermediaries between domestic savers and investors. Currently in China, this sterilization also magnifies the explosion in shadow banking by informal institutions not subject to reserve or capital requirements, or interest rate ceilings.
To better secure domestic monetary control, why doesn’t the PBC just give up intervening to set the yuan/dollar rate and let it float, i.e., be determined by the market? If the PBC withdrew from the foreign exchange market, the yuan would begin to appreciate without any well-defined limit. The upward pressure on the yuan has two principal sources:
- Extremely low, near-zero, short interest rates in the United States, United Kingdom, the European Union, and Japan. With the more robust Chinese economy having naturally higher interest rates, unrestricted hot money would flow into China. Once the yuan began to appreciate, carry traders would see even greater short-term profits from investing in yuan assets.
- China is an immature international creditor with underdeveloped domestic financial markets. Although China has a chronic saving (current account) surplus, it cannot lend abroad in its own currency to finance it.
Why not just lend abroad in dollars? Private (nonstate) banks, insurance companies, pension funds and so on, have a limited appetite for building up liquid dollar claims on foreigners when their own liabilities—deposits, insurance claims, and pension obligations— are in yuan. Because of this potential currency mismatch in private financial institutions, the PBC (which does not care about exchange rate risk) must step in as the international financial intermediary and buy liquid dollar assets on a vast scale as the counterpart of China’s saving surplus.
Even if there was no hot money inflow into China, the yuan would still be under continual upward pressure in the foreign exchanges because of China’s immature credit status (under the absence of a natural outflow of financial capital to finance the trade surplus). That is, foreigners remain reluctant to borrow from Chinese banks in yuan or issue yuan denominated bonds in Shanghai. This reluctance is worsened because of the threat from China bashing that the yuan might appreciate in the future. Thus the PBC has no choice but to keep intervening in the foreign exchanges to set and (hopefully) stabilize the yuan/dollar rate.
Superficially, the answer to China’s currency conundrum would seem be to fully liberalize its domestic financial markets by eliminating interest rate restrictions and foreign exchange controls. Then China could become a mature international creditor with natural outflows of financial capital to finance its trade surplus. Then the PBC need not continually intervene in the foreign exchanges.
This “internationalization” of the yuan may well resolve China’s currency conundrum in the long run. However, it is completely impractical—and somewhat dangerous—to try it in the short run. With near-zero short term interest rates in the mature industrial world, China would be completely flooded out by inflows of hot money, which would undermine the PBC’s monetary control and drive China’s domestic interest rates down much too far. China is in a currency trap. But within this dollar trap, China has shown that its GDP can grow briskly with even more rapid growth in wages—as long as the yuan-dollar rate remains reasonably stable. And China’s government must recognize that there is no easy way to spring the trap.
Ronald McKinnon is the William D. Eberle Professor Emeritus of International Economics at Stanford University, where he has taught since 1961. For a more comprehensive analysis of how the world dollar standard works, and China’s ambivalent role in supporting it, see Ronald McKinnon’s The Unloved Dollar Standard from Bretton Woods to the Rise of China, Oxford University Press (2013), and the Chinese translation from China Financial Publishing House (2013).
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Image credit: Beijing skyline and traffic jam on ring road, China. Photo by coryz, iStockphoto.