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