Cross-Posted at My Left Wing
China announced it will remove the Yuan’s Peg. This is a surprise move that caught everyone off-guard. “Under the new exchange rate mechanism, one dollar is valued at 8.11 yuan compared to the old rate of 8.2765 yuan, effectively a 2 pct revaluation”. According to a Reuters story:
“The yuan will now be allowed to trade in a tight 0.3 percent band against a basket of foreign currencies, the government said. It didn’t say which currencies.”
The Chinese have pegged the yuan at 8.28/dollar for what seems like forever. There are some who speculate this has undervalued the yuan by as much as 40%, making Chinese goods artificially cheap on the world currency markets.
It appears> the Chinese are looking to make the devaluation as orderly as the forex markets will allow. Their actual revaluation isn’t that large in the big picture, being a total of 2%. However, it is a start.
Currency pegging 101: When a country “pegs’ its currency to another currency (usually the US dollar) it creates a predetermined exchange rate. If the home currency (here the yuan) is undervalued, the home country has several options. The first – and by far the most popular — is to purchase other countries currencies. This creates artificial demand for the their currencies, raising its price relative to the home companies. This leaves the home country with a problem: it now has a large amount of another country’s currency. Usually the home country will purchase Treasury notes in the other country’s currency to make money on the foreign currency holding.
Here’s an example. Suppose China wants to peg the yuan to 8/dollar. However, the forex markets think the actual exchange rate is 4 yuan to the dollar. This means the forex markets thinks the yuan is more valuable relative to the dollar because forex traders think fewer yuan are needed for each dollar someone wants to exchange. The Chinese government will now start to purchase dollars in the open market. This makes the dollar more expensive relative to yuan. However, now the Chinese government has more dollars than it knows what to do with. Therefore, it starts to purchase US Treasury securities, which allows the Chinese government to get an interest payment on its dollar holdings.
This arrangement is one reason the Chinese currently own over 250 billion is US government securities. And therein lies an interesting rub. China is partly responsible for financing the US trade deficit. One of the causes of this financing is the yuan peg. If China no longer pegs to the yuan, they will no longer need to help finance the US trade deficit. That makes this very interesting from an international finance perspective.
In addition, a reavaluation is probably not the economic panacea many claim it will be. In fact, it may create more problems.
The first problem is the US will simply import products from somewhere else, as Alan Greenspan noted on Friday. “So essentially what we will find is we are importing from a different area but we’ll be importing the same goods,” Greenspan said. (“from Reuter’s story Fed: No trade perk from China revaluation). This is a classic example of what product substitution, where purchasers will simply seek out the cheapest price for a good, regardless of the source. There is little to argue against this statement. All that is required is a single company to obtain a cost advantage from purchasing from another country, and all of that company’s competitors will have to follow suit in order to remain equally competitive.
The second problem will be an increase in import prices from China, which Greenspan also noted. “The effect will be a rise in domestic prices in the United States and as a consequence of that, we will have other impacts which I could trace through but I’ve fortunately run out of time in this question.” The reason is simple. Suppose a US company purchases a good that costs 8.2 Yuan for a dollar (which is the current exchange rate more or less). If the Yuan increases in value relative to the dollar, each dollar will purchase fewer Yuan. So, in our previous example, suppose the Yuan appreciates to 4.1 Yuan to the dollar. Now the company must use 2 dollars for the same product. The company will have to increase the prices it charges in the US to make-up for the higher exchange rate. As a result, US import prices from China will increase.
The third problem could be an increase in US interest rates. As the article “What do yuant from us?” from the Economist notes, “In order to maintain the peg, China is forced to buy loads of dollars, which are then dumped into US Treasury bonds, financing America’s hefty deficits. A sudden decline in Chinese demand for Treasuries would raise America’s borrowing costs, curbing Congress’s ability to dole out pork to constituents. Some economists fear that this would push interest rates up sharply enough to cause a sharp contraction in the debt markets (including the mortgages that are fuelling America’s housing boom) and the economy–though this is unlikely, since the Chinese government seems keen to ensure that any appreciation occurs gradually.” This is an extreme situation, and as the article points out, may not occur.
The final problem, notes the Economist is “China accounts for less than one-tenth of America’s trade, so even a 10% revaluation would only reduce the trade-weighted value of the dollar by 1%–not enough to produce any noticeable change in America’s current account.” The US has a trade imbalance with several countries, only one of which is China. In other words, China is part of the problem, but not the entire problem. However, because of the recent swelling of Chinese textile imports they are a convenient political target.