More on Currency Manipulation

My previous post on currency manipulation elicited some excellent comments and responses, helping me, I hope, to gain a better understanding of the subject than I started with. What seemed to me the most important point to emerge from the comments was that the Chinese central bank (PBC) imposes high reserve requirements on banks creating deposits. Thus, the creation of deposits by the Chinese banking system implies a derived demand for reserves that must be held with the PBC either to satisfy the legal reserve requirement or to satisfy the banks’ own liquidity demand for reserves. Focusing directly on the derived demand of the banking system to hold reserves is a better way to think about whether the Chinese are engaging in currency manipulation and sterilization than the simple framework of my previous post. Let me try to explain why.

In my previous post, I argued that currency manipulation is tantamount to the sterilization of foreign cash inflows triggered by the export surplus associated with an undervalued currency. Thanks to an undervalued yuan, Chinese exporters enjoy a competitive advantage in international markets, the resulting export surplus inducing an inflow of foreign cash to finance that surplus. But neither that surplus, nor the undervaluation of the yuan that underlies it, is sustainable unless the inflow of foreign cash is sterilized. Otherwise, the cash inflow, causing a corresponding increase in the Chinese money supply, would raise the Chinese price level until the competitive advantage of Chinese exporters was eroded. Sterilization, usually conceived of as open-market sales of domestic assets held by the central bank, counteracts the automatic increase in the domestic money supply and in the domestic price level caused by the exchange of domestic for foreign currency. But this argument implies (or, at least, so I argued) that sterilization is not occurring unless the central bank is running down its holdings of domestic assets to offset the increase in its holdings of foreign exchange. So I suggested that, unless the Chinese central holdings of domestic assets had been falling, it appeared that the PBC was not actually engaging in sterilization. Looking at balance sheets of the PBC since 1999, I found that 2009 was the only year in which the holdings of domestic assets by the PBC actually declined. So I tentatively concluded that there seemed to be no evidence that, despite its prodigious accumulation of foreign exchange reserves, the PBC had been sterilizing inflows of foreign cash triggered by persistent Chinese export surpluses.

Somehow this did not seem right, and I now think that I understand why not. The answer is that reserve requirements imposed by the PBC increase the demand for reserves by the Chinese banking system. (See here.) The Chinese reserve requirements on the largest banks were until recently as high as 21.5% of deposits (apparently the percentage is the same for both time deposits and demand deposits). The required reserve ratio is the highest in the world. Thus, if Chinese banks create 1 million yuan in deposits, they are required to hold approximately 200,000 yuan in reserves at the PBC. That 200,000 increase in reserves must come from somewhere. If the PBC does not create those reserves from domestic credit, the only way that they can be obtained by the banks (in the aggregate) is by obtaining foreign exchange with which to satisfy their requirement. So given a 20% reserve requirement, unless the PBC undertakes net purchases of domestic assets equal to at least 200,000 yuan, it is effectively sterilizing the inflows of foreign exchange. So in my previous post, using the wrong criterion for determining whether sterilization was taking place, I had it backwards. The criterion for whether sterilization has occurred is whether bank reserves have increased over time by a significantly greater percentage than the increase in the domestic asset holdings of the PBC, not, as I had thought, whether those holdings of the PBC have declined.

In fact it is even more complicated than that, because the required-reserve ratio has fluctuated over time, the required-reserve ratio having roughly tripled between 2001 and 2010, so that the domestic asset holdings of the PBC would have had to increase more than proportionately to the increase in reserves to avoid effective sterilization. Given that the reserves held by banking system with the PBC at the end of 2010 were almost 8 times as large as they had been at the end of 2001, while the required reserve ratio over the period roughly tripled, the domestic asset holdings of the PBC should have increased more than twice as fast as bank reserves over the same period, an increase of, say, 20-fold, if not more. In the event, the domestic asset holdings of the PBC at the end of 2010 were just 2.2 times greater than they were at the end of 2001, so the inference of effective sterilization seems all but inescapable.

Why does the existence of reserve requirements mean that, unless the domestic asset holdings of the central bank increase at least as fast as reserves, sterilization is taking place? The answer is that the existence of a reserve requirement means that an increase in deposits implies a roughly equal percentage increase in reserves. If the additional reserves are not forthcoming from domestic sources, the domestic asset holdings of the central bank not having increased as fast as did required reserves, the needed reserves can be obtained from abroad only by way of an export surplus. Thus, an increase in the demand of the public to hold deposits cannot be accommodated unless the required reserves can be obtained from some source. If the central bank does not make the reserves available by purchasing domestic assets, then the only other mechanism by which the increased demand for deposits can be accommodated is through an export surplus, the surplus being achieved by restricting domestic spending, thereby increasing exports and reducing imports. The economic consequences of the central bank not purchasing domestic assets when required reserves increase are the same as if the central bank sold some of its holdings of domestic assets when required reserves were unchanged.

The more general point is that one cannot assume that the inflow of foreign exchange corresponding to an export surplus is determined solely by the magnitude of domestic currency undervaluation. It is also a function of monetary policy. The tighter is monetary policy, the larger the export surplus, the export surplus serving as the mechanism by which the public increases their holdings of cash. Unfortunately, most discussions treat the export surplus as if it were determined solely by the exchange rate, making it seem as if an easier monetary policy would have little or no effect on the export surplus.

The point is similar to one I made almost a year ago when I criticized F. A. Hayek’s 1932 defense of the monetary policy of the insane Bank of France. Hayek acknowledged that the gold holdings of the Bank of France had increased by a huge amount in the late 1920s and early 1930s, but, nevertheless, absolved the Bank of France of any blame for the Great Depression, because the quantity of money in France had increased by as much as the increase in gold reserves of the Bank of France.  To Hayek this meant that the Bank of France had done “all that was necessary for the gold standard to function.” This was a complete misunderstanding on Hayek’s part of how the gold standard operated, because what the Bank of France had done was to block every mechanism for increasing the quantity of money in France except the importation of gold. If the Bank of France had not embarked on its insane policy of gold accumulation, the quantity of money in France would have been more or less the same as it turned out to be, but France would have imported less gold, alleviating the upward pressure being applied to the real value of gold, or stated equivalently alleviating the downward pressure on the prices of everything else, a pressure largely caused by insane French policy of gold accumulation.

The consequences of the Chinese sterilization policy for the world economy are not nearly as disastrous as those of the French gold accumulation from 1928 to 1932, because the Chinese policy does not thereby impose deflation on any other country. The effects of Chinese sterilization and currency manipulation are more complex than those of French gold accumulation. I’ll try to at least make a start on analyzing those effects in an upcoming post addressing the comments of Scott Sumner on my previous post.


19 Responses to “More on Currency Manipulation”

  1. 1 Dani C November 9, 2012 at 4:14 am

    Great analysis. Hope you don’t mind me linking to your blog at Thanks for all your contributions!

    Dani C


  2. 2 John November 9, 2012 at 4:17 am


    I believe this post is a real service. Well done.

    I also am going to take credit for having pushed you to do the work. Had I not gotten involved and gotten some support, you would have drifted away.

    I have never said that Macro has no value. But I will say that Macro has little value until we truly understand the micro of banking, and get it right.

    In sum, I have two points.

    All current Macro models likely are wrong because they assume micro foundations of banking are in good order and there is no evidence of such.

    All Macro models are wrong because, for example, the models of the 1930s did not consider the public’s future expectations in a World with Hitler and Stalin.

    Above you write about Hayek, France, and gold. What a waste. Even if France had done something different, do you think, given the rise of Hitler, that France’s economy would have performed differently.

    The idea of full employment in a world with Hitler and Stalin is madness


  3. 3 David C November 9, 2012 at 6:29 am

    I would be interested in your take on the Swiss situation. There is an asymmetrical currency peg against the Euro. The Swiss National Bank has been,until very recently, printing Swiss Francs and buying Euros to keep the exchange rate at least 1.2CHF/Euro. There has been a rapid increase in the Fx reserves at the SNB, and relatively stable prices (perhaps a bit of deflation starting to show up).


  4. 4 Ritwik November 9, 2012 at 2:54 pm

    David C

    Currency peg when there is upwards pressure on the currency due to safe asset status will basically lead to an appreciation of asset prices in the locally denominated currency, as indeed has been the case in Switzerland – esp. real estate. The currency peg essentially acts as a massive subsidy to Eurozone savers who want Swissie assets. It’s unlikely to work wonders for CPI or wage inflation, and indeed the Swiss experience shows precisely that.

    Note that unemployment can still be down. High asset prices can work wonders to keep employment up for some time. Indeed, the second half of the Greenspan era was precisely this.

    Of course, one could argue that without the peg Switzerland will be facing outright deflation much worse than it has seen. There’s no way to really know. You’ll also here arguments that the reason SNB has failed to reflate despite the currency peg is because it has failed to adopt the second part of Svensson’s foolproof method – an explicit inflation target. There’s some merit to that as well, though again, we won’t really know.

    What we do know is that SNB Fx reserves are on the way up, asset prices are on the way up, unemployment is low but there’s no CPI/wage inflation pick-up in sight.


  5. 5 David Glasner November 11, 2012 at 10:52 am

    Dani C, Not at all, and thank you.

    John, Glad that you liked it. To coin a phrase: it takes a blog. We all gain from having a conversation and hearing each other out. The solitary researcher who figures it all out for himself hardly ever exists.
    If the Bank of France and the Fed had not produced the Great Depression, Hitler might have rated no more than a footnote in history. Of course, that would not have taken care of Stalin.

    David C, I am afraid that I have little to add to Ritwik’s comments. The Swiss situation is fundamentally different from the Chinese situation; it is not driven by an undervaluation of Swiss franc, but by a desire by the non-Swiss to hold Swiss francs.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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