Foreign Exchange

We analyzed key motives for purchasing foreign exchange. These are:

  • speculation
  • imports
  • portfolio considerations (purchasing US$ assets)
  • direct foreign investment (developing oilfields and building factories and purchasing companies to operate them, eg, not “portfolio”)
  • earn returns (eg, interest)

We focused on the latter as an empirically relevant factor in currency movements (take Econ 271 for details), while noting that speculation is huge but generally neutral (forex traders keeping busy when their phones aren’t ringing). Domestic inflation should over time make it harder to export and increase imports; a currency depreciation offsets that (“purchasing power” and “law of one price”). But lately inflation in China has been low, at least in comparison to productivity increases (which, ceteris paribus, leads to a currency appreciation.

One US policy complaint is of “closed” capital markets. Of course some US companies would like fewer strictures on buying domestic Chinese firms and selling financial services. The latter interest leads naturally to a desire to sell existing global portfolio products. Currently they can’t. And it’s not that they would receive a cold shoulder: Chinese retirement funds have no international diversification. Relaxing rules on buying US$ assets would quite reasonably lead to hundreds of billions of dollars flowing out. If that were to occur, it would lead to a substantial appreciation of the dollar, eg, from 元6.8/US$1 to 元7.0/US$1 or higher – with the “unlucky number seven” a red line in the sand. But at FTAlphaville notes, “The renminbi now sits at Rmb6.87 per dollar, having lost 6.5 per cent of its value since June. … China’s currency fluctuations have everything to do with the trade war, which entered its latest round earlier this week,” noting that a depreciation partially offsets the impact of US tariffs.

Now for a decade China ran very large trade surpluses, with the People’s Bank of China [the central bank], which poured dollars into the foreign exchange market, offsetting outflows of RMB / yuan / kuai (块) searching for foreign assets. As we will see, that surplus is now smallish, relative to GDP and to past levels of trade surpluses. So how can China hold off a depreciation? And avoid being labeled a “currency manipulator” (as detailed in US law, or at least Congressional discussions).

In addition, China is now large enough that its behavior impacts global markets. In particular, further depreciation begs parallel depreciation by other developing countries so that they can maintain parity in global markets for their own (labor intensive) exports. But while China has no foreign-currency-denominated debt, that’s not true for the rest of Asia and South America and Africa. Think Argentina this year or (not something you remember!) the July 1997 Asian Financial Crisis, when the many Thai companies that had borrowed at Baht20/$ were rendered bankrupt when the currency fell to Baht40/$ between the start and the end of business on Wednesday, July 2. Changes in the value of the RMB were a contributing factor.

Brian Setser at The Council on Foreign Relations provides an update on the how (and some on the why). The key is China’s sales of foreign reserves. Those were effectively nil in 2000 but are large today – US$3.2 trillion. But they’re no longer rising. Is that because China is no longer earning foreign exchange via its “ordinary” trade and foreign investment activities? Those certainly are down, and we will look at that periodically during the remainder of the term. In addition, the accounting is unclear. Foreign reserves of $3 trillion ought to be earning at least 2% a year, or $15 billion a quarter. Is that being sold? Absent such accounting lacunae, recent interventions appear to be small. Just 2 years ago the exchange rate was effectively constant during normal US business hours. That’s no longer true, as per the black and yellow lines.

Note that the reference rate in this chart is a currency basket. China trades with the world as a whole, not just the US, so it makes sense for them to link to a trade-weighted average of their global partners. Sorry, can we refer to China as a partner? The official US stance is that trade is war, not a mutually beneficial endeavor driven by the “invisible hand” of private parties. Since China runs a bilateral surplus they must therefore be an enemy.

About Mike

Prof of Economics, Wms School of Commerce, Washington and Lee University, Lexington VA
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5 Responses to Foreign Exchange

  1. Joe Wen says:

    During the recent trade war, many speculators state that China is starting to run out of its US tariff arsenal. However, some argue that China still holds the aces – its enormous holding of U.S. debt ($1.17 trillion). It seems like China is capable of doing some sizable damage if it decides to unload its liquid U.S. financial assets significantly. However, it is very debatable if this option is viable or whether it can actually cause any damage to the U.S.

    Unloading the U.S. bonds will cause a significant capital outflow from China to the U.S., which is the exact thing the Chinese government aims to avoid. Technically, if China sells a sizable chunk of U.S. bonds, it can spike the supply of treasuries, causing yields to rise; consequently, the borrowing cost increases for U.S. companies and consumers and the U.S. economy slows down.

    Besides, the potential self-inflicted capital losses are too large to take on if China decides to do so. If a major selloff is triggered globally, China would take on a heavy loss on the sale as treasury prices plummet. Besides, the dollars would likely to fall, making U.S. export more attractive, which hurts China’s export.

    Although it is not likely for China to dump a large chunk of U.S. treasury as a weapon, there are other ways China can leverage their U.S. debt position. For example, a halt in buying U.S. treasuries when the bonds are at maturity can be a gradual weapon against the U.S.

    As of now, I believe China currently does not have as much ammo as the U.S. does in terms of the tariff battle. However, it is likely that China will aim to increase the U.S. trade deficit as the yuan devalues. We shall see how things play out, and hopefully no major damage is done through dramatic actions by either country.

  2. Jonathan says:

    China is fairly notorious for its massive holdings of foreign currencies, not limited to just the USD. This has caused concerns for many nations, as they are at risk of rapid inflation if China decides to flood the market with their holdings. This has also lead many to accuse China of holding onto these currencies for the purpose of controlling the exchange rate of their own.

    However, I do not believe that China would be inclined to conduct a large selloff of foreign assets. This would remove much of their leverage power in financial markets, and a large influx of dollars would reduce the value of the United States debt that China holds much of, and potentially lose out on interest income.

    In the future, China may bow to pressure from other countries to cease its efforts to stabilize its currency through shady means. Perhaps it will then turn to finding new ways, such as increasing trade. For the time being, China will likely find ways to control markets through the current trade war without resorting to currency dumps.

  3. Pat DiTondo says:

    It is very interesting to consider that opening up Chinese capital markets to the world would actually cause an appreciation of the dollar as Chinese savers would seek to purchase dollar-dominated US financial assets. I am intrigued to know how the expected magnitude of this event was calculated, wouldn’t there also be an increased demand for Chinese financial assets as the rest of the world attempts to gain access to Chinese economic growth? Regardless of the magnitude this helps to shed light on the predicament that Chinese leadership faces: if they open up their capital markets they risk a depreciation of their currency that would promote US accusations of currency manipulation.

    I do not fully understand the logic behind US fears of Chinese ownership of our debt, especially since it is dominated in US dollars. Do the creditors to a sovereign-nation really have much bargaining power over policy decisions? The Chinese have little to fear over their treasury holdings given that a US default on debt would be a global economic catastrophe of a massive scale, with many concerns beyond the potential wiping out of their capital.

    • Max Lou says:

      I also agree with you that the fears of Chinese ownership of our debt is not merited. A statistic from 2016 shows that in addition to China owning only 9.5% of our Public Portion of the National debt, Japan owns another 8.0% of our debt and we don’t seem to be worried about them (MyGovCost).

      In addition to the fact that a US default would cause a global economic crisis I doubt the US would ever come into a situation of defaulting on its debt as the US government has the ability to tax the citizenships/corporations of the wealthiest country in the world. (in terms of largest economy nominally)

      I think although hundred of billions of dollars would be flowing out I don’t think that is necessarily a bad thing. Chinese people could diversify their portfolios (less risk) and have more options for investment opportunity. Also, would a depreciation of the Chinese currency make Chinese exports more competitive abroad? I do think that is outflow of cash could be balanced if US companies could buy domestic Chinese firms as they would need Chinese currency to do that. If this were to be allowed. I don’t think there would be too much appreciation of the US currency.

  4. John says:

    In analyzing the effects that opening up capital markets in China, it becomes evident that the Chinese RMB would actually depreciate in relation to the USD, which is interesting. The line in the sand of 7.0 RMB to 1 USD would be surpassed, as hundreds of billions of dollars would flow out of Chinese domestic investments. Whether this outflow would be counterproductive is reliant on whether hitting the 7RMB-1USD level of depreciation actually has true negative effects. I would be interested in learning more about the ways in which China has leverage on the US through the US debt held by China. I am interested to see what ways China attempts to control US economic decision making in the near future.

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