Mitt Romney is promising to declare China a currency manipulator on “day one” of his new administration. Why? Ostensibly, because Mr. Romney, like so many others, believes that the Chinese are somehow interfering with the foreign-exchange markets and holding the exchange rate of their currency (confusingly called both the yuan and the remnibi) below its “true” value. But the other day, Mary Anastasia O’Grady, a member of the editorial board of the avidly pro-Romeny Wall Street Journal, wrote an op-ed piece (“Ben Bernanke: Currency Manipulator” ) charging that Bernanke is no less a currency manipulator than those nasty Chinese Communists. Why? Well, that was not exactly clear, but it seemed to have something to do with the fact that Mr. Bernanke, seeking to increase the pace of our current anemic recovery, is conducting a policy of monetary expansion to speed the recovery.
So, is what Mr. Bernanke is doing (or supposed to be doing) really the same as what the Chinese are doing (or supposed to be doing)?
Well, obviously it is not. What the Chinese are accused of doing is manipulating the yuan’s exchange rate by, somehow, intervening in the foreign-exchange market to prevent the yuan from rising to its “equilibrium” value against the dollar. The allegation against Mr. Bernanke is that he is causing the exchange rate of the dollar to fall against other currencies by increasing the quantity of dollars in circulation. But given the number of dollars in circulation, the foreign-exchange market is establishing a price that reflects the “equilibrium” value of dollars against any other currency. Mr. Bernanke is not setting the value of the dollar in foreign-exchange markets, as the Chinese are accused of doing to the dollar/yuan exchange rate. Even if he wanted to control the exchange value of the dollar, it is not directly within Mr. Bernanke’s power to control the value that participants in the foreign-exchange markets attach to the dollar relative to other currencies.
But perhaps this is too narrow a view of what Mr. Bernanke is up to. If the Chinese government wants the yuan to have a certain exchange value against the dollar and other currencies, all it has to do is to create (or withdraw) enough yuan to ensure that the value of yuan on the foreign-exchange markets falls (or rises) to its target. In the limit, the Chinese government could peg its exchange rate against the dollar (or against any other currency or any basket of currencies) by offering to buy and sell dollars (or any other currency or any basket of currencies) in unlimited quantities at the pegged rate with the yuan. Does that qualify as currency manipulation? For a very long time, pegged or fixed exchange rates in which countries maintained fixed exchange rates against all other currencies was the rule, not the exception, except that the pegged rate was most often a fixed price for gold or silver rather than a fixed price for a particular currency. No one ever said that simply maintaining a fixed exchange rate between one currency and another or between one currency and a real commodity is a form of currency manipulation. And for some 40 years, since the demise of the Bretton Woods system, the Wall Street Journal editorial page has been tirelessly advocating restoration of a system of fixed exchange rates, or, ideally, restoration of a gold standard. And now the Journal is talking about currency manipulation?
So it’s all very confusing. To get a better handle on the question of currency manipulation, I suggest going back to a classic statement of the basic issue by none other than John Maynard Keynes in a book, A Tract on Monetary Reform, that he published in 1923, when the world was trying to figure out how to reconstruct an international system of monetary arrangements to replace the prewar international gold standard, which had been one of the first casualties of the outbreak of World War I.
Since . . . the rate of exchange of a country’s currency with the currency of the rest of the world (assuming for the sake of simplicity that there is only one external currency) depends on the relation between the internal price level and the external price level [i.e., the price level of the rest of the world], it follows that the exchange cannot be stable unless both internal and external price levels remain stable. If, therefore, the external price level lies outside our control, we must submit either to our own internal price level or to our exchange rate being pulled about by external influences. If the external price level is unstable, we cannot keep both our own price level and our exchanges stable. And we are compelled to choose.
I like to call this proposition – that a country can control either its internal price level or the exchange rate of its currency, but cannot control both — Keynes’s Law, though Keynes did not discover it and was not the first to articulate it (but no one else did so as succinctly and powerfully as he). So, according to Keynes, whether a country pegs its exchange rate or controls its internal price level would not matter if the price level in the rest of the world were stable, because in that case for any internal price level there would be a corresponding exchange rate and for every exchange rate there would be a corresponding internal price level. For a country to reduce its own exchange rate to promote exports would not work, because the low exchange rate would cause its internal prices to rise correspondingly, thereby eliminating any competitive advantage for its products in international trade. This principle, closely related to the idea of purchasing power parity (a concept developed by Gustav Cassel), implies that currency manipulation is not really possible, except for transitory periods, because prices adjust to nullify any temporary competitive advantage associated with a weak, or undervalued, currency. An alternative way of stating the principle is that a country can control its nominal exchange rate, but cannot control its real exchange rate, i.e, the exchange rate adjusted for price-level differences. If exchange rates and price levels tend to adjust to maintain purchasing power parity across currency areas, currency manipulation is an exercise in futility.
That, at any rate, is what the theory says. But for any proposition derived from economic theory, it is usually possible to come up with exceptions by altering the assumptions. Now for Keynes’s Law, there are two mechanisms causing prices to rise faster in a country with an undervalued currency than they do elsewhere. First, price arbitrage between internationally traded products tends to equalize prices in all locations after adjusting for exchange rate differentials. If it is cheaper for Americans to buy wheat in Winnipeg than in Wichita at the current exchange rate between the US and Canadian dollars, Americans will buy wheat in Winnipeg rather than Wichita forcing the Wichita price down until buying wheat in Wichita is again economical. But the arbitrage mechanism works rapidly only for internationally traded commodities like wheat. Many commodities, especially factors of production, like land and labor, are not tradable, so that price differentials induced by an undervalued exchange rate cannot be eliminated by direct arbitrage. But there is another mechanism operating to force prices in the country with an undervalued exchange rate to rise faster than elsewhere, which is that the competitive advantage from an undervalued currency induces an inflow of cash from other countries importing those cheap products, the foreign cash influx, having been exchanged for domestic cash, becoming an additional cause of rising domestic prices. The influx of cash won’t stop until purchasing power parity is achieved, and the competitive advantage eliminated.
What could prevent this automatic adjustment process from eliminating the competitive advantage created by an undervalued currency? In principle, it would be possible to interrupt the process of international arbitrage tending to equalize the prices of internationally traded products by imposing tariffs or quotas on imports or by imposing exchange controls on the movement of capital across borders. All of those restrictions or taxes on international transactions prevent the price equalization implied by Keynes’s Law and purchasing power parity from actually occurring. But after the steady trend of liberalization since World War II, these restrictions, though plenty remain, are less important than they used to be, and a web of international agreements, codified by the International Trade Organization, makes resorting to them a lot trickier than it used to be.
That leaves another, less focused, method by which governments can offer protection from international competition to certain industries or groups. The method is precisely for the government and the monetary authority to do what Keynes’s Law says can’t be done: to choose an exchange rate that undervalues the currency, thereby giving an extra advantage or profit cushion to all producers of tradable products (i.e., export industries and import-competing industries), perhaps spreading the benefits of protection more widely than governments, if their choices were not restricted by international agreements, would wish. However, to prevent the resulting inflow of foreign cash from driving up domestic prices and eliminating any competitive advantage, the monetary authority must sterilize the induced cash inflows by selling assets to mop up the domestic currency just issued in exchange for the foreign cash directed toward domestic exporters. (The classic analysis of such a policy was presented by Max Corden in his paper “Exchange Rate Protection,” reprinted in his Production, Growth, and Trade: Essays in International Economics.) But to borrow a concept from Austrian Business Cycle Theory, this may not be a sustainable long-run policy for a central bank, because maintaining the undervalued exchange rate would require the central bank to keep accumulating foreign-exchange reserves indefinitely, while selling off domestic assets to prevent the domestic money supply from increasing. The central bank might even run out of domestic assets with which to mop up the currency created to absorb the inflow of foreign cash. But in a rapidly expanding economy (like China’s), the demand for currency may be growing so rapidly that the domestic currency created in exchange for the inflow of foreign currency can be absorbed by the public without creating any significant upward pressure on prices necessitating a sell-off of domestic assets to prevent an outbreak of domestic inflation.
It is thus the growth in, and the changing composition of, the balance sheet of China’s central bank rather than the value of the dollar/yuan exchange rate that tells us whether the Chinese are engaging in currency manipulation. To get some perspective on how the balance sheet of Chinese central banks has been changing, consider that Chinese nominal GDP in 2009 was about 2.5 times as large as it was in 2003 while Chinese holdings of foreign exchange reserves in 2009 were more than 5 times greater than those holdings were in 2003. This means that the rate of growth (about 25% a year) in foreign-exchange reserves held by the Chinese central bank between 2003 and 2009 was more than twice as great as the rate of growth in Chinese nominal GDP over the same period. Over that period, the share of the total assets of the Chinese central bank represented by foreign exchange has grown from 48% in December 2003 to almost 80% in December 2010. Those changes are certainly consistent with the practice of currency manipulation. However, except for 2009, there was no year since 2000 in which the holdings of domestic assets by the Chinese central bank actually fell, suggesting that there has been very little actual sterilization undertaken by the Chinese central bank. If there has indeed been no (or almost no) actual sterilization by the Chinese central bank, then, despite my long-standing suspicions about what the Chinese have been doing, I cannot conclude that the Chinese have been engaging in currency manipulation. But perhaps one needs to look more closely at the details of how the balance sheet of the Chinese central bank has been changing over time. I would welcome the thoughts of others on how to interpret evidence of how the balance sheet of the Chinese central bank has been changing.
At any rate, to come back to Mary Anastasia O’Grady’s assertion that Ben Bernanke is guilty of currency manipulation, her accusation, based on the fact that Bernanke is expanding the US money supply, is clearly incompatible with Max Corden’s exchange-rate-protection model. In Corden’s model, undervaluation is achieved by combining a tight monetary policy that sterilizes (by open-market sales!) the inflows induced by an undervalued exchange rate. But, according to Mrs. O’Grady, Bernanke is guilty of currency manipulation, because he is conducting open-market purchases, not open-market sales! So Mrs. O’Grady has got it exactly backwards. But, then, what would you expect from a member of the Wall Street Journal editorial board?
PS I have been falling way behind in responding to recent comments. I hope to catch up over the weekend as well as write up something on medium of account vs. medium of exchange.
PPS Thanks to my commenters for providing me with a lot of insight into how the Chinese operate their monetary and banking systems. My frequent commenter J.P. Koning has an excellent post and a terrific visual chart on his blog Moneyness showing the behavior over time of the asset and liability sides of the Chinese central bank. Scott Sumner has also added an excellent discussion of his own about what Chinese monetary policy is all about. I am trying to assimilate the various responses and hope to have a further post on the subject in the next day or two.
Uneasy Money 
David, you are so right. The discussion about these issues seems to be rather insane and uninformed in the US.
Romney’s talk about China is rather scary and unfortunately Obama is not much different on the issue of trade.
The concept of “currency manipulation” simply useless – too bad an institution like the IMF plays along with these idiotic concepts.
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David,
There is a capital account and a current account. The capital account is adjusted to reflect capital investments between countries (purchases of stocks and bonds). The current account includes trade flows, land / property purchases, etc. The two must always sum to zero.
What Mitt Romney is complaining about is a result of listening to economists who promote free trade without free capital movement. China maintains a currency peg by imposing capital restrictions on its population (similar to what a lot of war torn countries did after World War II). Meaning people in China cannot take their earnings, convert them to another currency, and invest them abroad. It also means that foreign direct investment into China is strictly controlled.
Courtesy of a trade imbalance, China also imports capital from the sale of goods. And so China must recycle excess capital into something to maintain the peg – US Treasuries.
And so there are two ways to resolve this – either ignore the economists and embrace both free trade AND free capital movement (picture Chinese ownership of Boeing and JP Morgan) or sell fewer Treasuries.
But since it appears that Romney (and his economic team – Mankiw, Hubbard, et al) are not serious about either approach, they bark at the moon.
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David, for what it’s worth, I agree with you on this point and Lars on the aspect of “scary.” On both sides of the political aisle we get awful theories like this one, those consistent with liquidation, or those that welcome the devastation of Hurricane Sandy as being beneficial for the economy. Contemplation of the future makes me shudder.
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If you engineer a capital account deficit, you will automatically also be engineering a current account surplus. This isn’t complicated. The only thing that makes this complicated is the power of the US financial sector which benefits from massive capital inflows at the expense of the US tradable goods sector which has been absolutely devastated over the last thirteen years. As a result of the evisceration of US manufacturing, I’d be willing to bet 500,000 RMB the US will be an extremely poor country within five to ten years and will drop out of the ranks of “high income” countries as defined by the UN.
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Follow up:
This is an “American” way of looking at how the People’s Bank of China “sterilizes” its currency interventions. Chinese economic institutions are not exact mirrors of US institutions, much to the disappointment of American analysts. The Chinese can offset the inflationary effects of an undervalued currency in ways other than accumulating domestic bonds, and they have done so: the two principle means: (1) increasing bank reserve requirements which are now two to three times higher than in the US; and (2) administrative intervention. The central government has been continuously haranguing and punishing companies, particularly retailers (foreign retail chains like Wal Mart and Carrefour are a prime target) for raising prices. They’ve also reigned in property market prices by limiting real estate purchases to one unit per family.
The moral of the story: US economists need to stop being such provincials.
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David,
It seems to me that you do not understand how China works. First the facts, then we can take up the rest.
As Roach has explained, China manipulates its currency by having its banks be the only place where $$$ can be exchanged for yuan. He says that there is no market where $$$ and yuan are exchanged. Instead, when a Chinese company is paid in $$$, the sole source of yuan with which it can pay its local bills are the banks in China. According to Roach, the Banks in China control the money supply by limiting the amount of yuan they will exchange, creating a shortage of money and thus limiting domestic demand. He says that this lack of money is evidenced by bank lending or local gov’t investing, etc., being the source of capital in China, as opposed to private capital. IOW, most all investment is financed, directly or indirectly, by bank loans.
If there is a price difference external to China, such does not matter. Cheap wheat in Canada is meaningless, for private firms do not have access to foreign exchange under this system. They only have yuan. If yuan is taken to the Bank to exchange for canadian $$$, not enough canadian $$$ are exchanged to make it possible to buy cheap wheat.
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“It is thus the growth in, and the changing composition of, the balance sheet of China’s central bank rather than the value of the dollar/yuan exchange rate that tells us whether the Chinese are engaging in currency manipulation”
This is exactly, exactly, exactly right.
Further, I would say that even looking at the % share of composition is only an initial indicator. I would attack the problem from the perspective of inventory theory – Fx reserves are after all safety stock in the case of Fx demand – and I hope to be able to write a comprehensive post about this for at least the Indian perspective very soon. Am just searching for data on Fx currency accounts in India which seems to be not easily available.
Frank Restly
Ca + KA = 0 is commonly asserted, but KA includes Fx accumulation by the central bank. So the identity is better asserted as KA + CA = delta (Fx reserves).
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John is right, the key to China’s currency regime is financial repression that ensures the CB the domestic assets it needs for sterilization. Here’s a good overview by Michael Pettis, including references to Robert Aliber’s model of currency manipulation and financial repression.
http://www.mpettis.com/2010/06/15/china-wheres-the-inflation/
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David, this is really an excellent theoretical overview of international economics and its application to real life. Thanks for this.
“However, except for 2009, there was no year since 2000 in which the holdings of domestic assets by the Chinese central bank actually fell, suggesting that there has been very little actual sterilization undertaken by the Chinese central bank. If there has indeed been no (or almost no) actual sterilization by the Chinese central bank, then, despite my long-standing suspicions about what the Chinese have been doing, I cannot conclude that the Chinese have been engaging in currency manipulation. But perhaps one needs to look more closely at the details of how the balance sheet of the Chinese central bank has been changing over time. I would welcome the thoughts of others on how to interpret evidence of how the balance sheet of the Chinese central bank has been changing.”
It’s been a while since I looked at the PBoC’s (People’s Bank of China) balance sheet. But I do recall that the PBoC sterilizes not by selling domestic assets, but by requiring domestic banks to subscribe to ever growing amounts of central bank-issued sterilization bonds. That way the central bank can mop up domestic currency. That’s why (as you point out in your post) you don’t see holdings of domestic assets by the PBoC falling, but I’m pretty sure sterilization is occurring via the liability side of the PBoC’s balance sheet. But I’d have to verify. Maybe I can get back to you on this… it’s late and I’m tired.
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David
Now that we have an agreement on what is happening, I would not advance the proposition that what China is doing is not currency manipulation. China is one giant merchant banking economy only the merchant banks are state owned. There is no significant equity capital (juan) in the economy. Capital, when needed, comes from bank loans.
The question then is whether merchant banking can operate on such a scale.
If hedge funds can, why not merchant banks?
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David. I’ve cooked up a chart of the People’s Bank of China balance sheet here.
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David,
A brief addition to my last note.
It seems to me that in discussing China economists have committed the sin of confusing the familiar with the necessary. We have equity markets. Therefore, the assumption has been made that capitalism requires “equity,” but it doesn’t. Merchant banking can provide, through the power of any deposit taking firm to create money under the necessary conditions, investment money in the same way that equity does. In fact, merchant banking can provide more because it can create more money than can equity through a stock market. Under such circumstances, the challenge for merchant banking is whether it can write off bad loans as promptly as such need to be written off. We shall see.
My two cents, btw, is that both systems are confidence games and neither has shown itself superior at creating and keeping confidence.
The prudent flight of the individual investor from our equity markets indicts anyone who claims our way is superior to Chinese style merchant banking.
To the point, I would argue that what you and other macro economists should have learned from the Depression that started on June 22, 2007, when Bear Stearns pledged a collateralized loan of up to $3.2 billion to “bail out” one of its funds, the Bear Stearns High-Grade Structured Credit Fund is that such represented a failure of finance at the micro level (and not a failure of macro).
Macro assumes that our laws and institutions to provide finance work. Since all of you “macro” guys are, Munger’s words, men only with hammers, you never ask, Could all of this have happened because of micro level failure of finance. Having been in micro for 35 years, I would argue that our laws and institutions are completely broken and are the cause of our problems. In a nutshell, our banks are far to big (and shouldn’t be public at all) and they are prohibited from providing the services they need to provide to borrowers. In lieu of BofA and Chase, we need tens of thousands of small, private banks that can only make non-recourse loans.But, who wants to talk about banking, something we can change, when we can complain about the weather.
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Interesting blogging.
A kooky topic.
To top it all off, we print money in the USA, an international reserve currency. That means we print slips of paper, and give it foreigners, who ship us goods and services.
That’s a great deal. We should print even more money to give to foreigners.
Eventually, they can either buy goods and services back from us (slightly lowering our living standards, as part of our output will be consumed offshore) or buy USA assets.
Romney may or may not believe what he says, since he has said almost anything in the last 10 years, on every side of every issue. He would tell you that himself, if he thought it would help him get elected.
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JP Koning has a truly informative chart. The foreign exchange holdings–stunning.
The only way one can understand that chart is to be lawyer trained in critical legal studies. No rules of economics are driving that system of finance. To the opposite, those with political power are making the laws of finance for their own purposes. Money and finance are legal and political, not economics.
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Lars, Thanks, but I am not myself convinced that the Chinese are not, in some sense, manipulating their currency. My main aim was to try to develop a conceptual framework that makes it possible to answer the question. As I indicate, I am not at all sure that I am interpreting the evidence correctly, and the further comments below seem to bear this out. I think we still need to think this through. All I am sure about is that Mrs. Mary Anastasia O’Grady is thoroughly confused.
Frank, Where have you seen any economists working for Romney say that they are against free capital movement? It is not economists but politicians (of all stripes) who oppose Chinese purchase of US assets.
dajeeps, I share your angst, but, as I responded above to Lars, the point of this post is not so much to bash Romney as to ask what is the correct way to assess what the Chinese are doing. I don’t have a conclusion, just a tentative conjecture based on an incomplete, and not completely informed, assessment of the evidence.
Gus I, I think that you have a point, but exaggerating it hugely.
Gus, II, These are interesting observations, which are worth taking account of. Thanks.
John, Explain this to me. If I am a Chinese exporter and I receive $10,000 for an order and I take the $10k to the bank, what happens? Are you saying that I can’t get back as many yuan as the $10k is worth at the official exchange rate? If you are not saying that, how is the number of yuan being restricted by the Chinese gov’t and the central bank? About price differences, my argument is that prices are chronically lower in China than elsewhere so Chinese are not being prevented from arbitraging price differences, but perhaps they would are trying to import more Buicks from the US and BMWs from Germany than they are being allowed to do by being prevented from getting dollars or euros to make such purchases. On the other hand, why aren’t Chinese exporters getting paid in dollars using those dollars to pay for imports? Presumably they can’t hold dollars in bank accounts either.
Ritwik, Glad to hear that you agree. Please let us know when your post is done.
OGT, I agree that financial repression is an important part of the story that needs to be taken into account. Thanks for the link to Pettis.
JP, Glad to be of service. You make a very important point that helps complete the story. The post and diagram discussing this issue on your blog are terrific. Thank you!
John, I agree that we need to look more deeply at what is going on in the Chinese central bank than I did, but I am not sure calling China a merchant bank really helps us (or at least moi) understand what’s going on.
I agree that there are huge issues that need to get sorted out in the micro side of banking, and there is clearly interaction between the microside of banking and the larger macro-effects. But I don’t think that that means that macro is useless.
Ben, Thanks. Good to hear from you again. In principle, we are made better off by shipping dollars abroad for real stuff, but that is not a stable equilibrium. It seems to produce other effects that aren’t so welcome.
John, Sorry, but you are losing me.
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China is of course manipulating its currency. It has to in order to stay competitive. If China does not keep its currency low, how can it continue to stay competitive? It does not have a choice.
The world is at war – Currency War!
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David
You need to learn to think like a banker, if you are going to understand what is actually happening.
I apologize for posting too much. I have accomplished my goal which was to get you to focus on the micro side of banking, which, fwiw, based on 35 years in banking, is what is broken. I cannot push the string more than getting someone like you to start talking about such. My two cents is that you are talented and in a position to write and push, whereas your looking back may be interesting to you but such is very unproductive
You ask, Are you saying that I can’t get back as many yuan as the $10k is worth at the official exchange rate?
That is exactly what I am saying. Let’s say you show up with $10,000 and ask for yuan at the exchange rate. I will bet dollars to donuts that the answer is as follows (which can be given in a million variants). David, we need you to apply $2,000 to you line of credit, as we are feeling a little insecure.
The mistake you make is that you think borrowers are independent of banks. Never forget that in substance the borrower is the highest paid employee of the bank, subject to more control than any other employee, and nothing more.
My 2 cents is that China is a giant merchant bank and that what it is actually manipulating is preventing accumulation of private equity (that $2000) as a meaningful source of investment. We feel this as currency manipulation but I believe it is something far different.
To understand my point, consider Muslim countries that forbid lending of money at interest. This is not to protect borrowers. This is to enhance the power of lenders and to conceal that power. Instead of a loan, if you have a new idea you either (and mostly) become an employee. Sometimes you get to be a minority partner in the new enterprise. Majority owner, never.
5000 years ago Egyptians borrowed money and built the Great Pyramids. Today, you cannot borrow 50 cents in Cairo and you won’t even find Egyptian sandals at WalMarts.
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David
Someone above asked, cannot you take your $$$ and go buy something to import?
The answer is no for two reasons. First, tariffs (China still has them) Second, because of the limited amount of yuan in circulation, where is the yuan going to come from to pay you?
A good way to learn about this problem is to read a little about the conditions giving rise to the Constitution. The Colonies had no money to pay for imports. When a Morris ship left for China, full of all the local silver to be used to buy goods in China, the sailing of the ship would literally cause a local recession.
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Forex Mentor Pro, My point is that currency manipulation involves more than the choice of an exchange rate. As far as I am concerned China can peg its currency at any rate it wants to against the dollar, but if it does it should not sterilize the inflows of cash with which foreigners are paying for the products China is exporting. And China does have a choice; and currency war is just a metaphor.
John, No need to apologize. I write about what I think is interesting and what I think I have something intelligent to say. So far, I haven’t come up with much to say about how to fix banking, so you need to keep explaining things to me. And, for sure I do not think like a banker.
What do you mean by “apply $2000 to your line of credit?” Does that mean reduce my indebtedness to the bank by $2000? That’s not exactly the same as not crediting the customer with the equivalent of the $10k that he wanted to exchange with the bank.
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