China is Not Manipulating its Currency

Senators Kay Hagan (D) and Richard Burr (R) of North Carolina recently introduced a bill that would enlist the Department of Commerce to deal with the problem of Chinese Currency manipulation.  The accusation is a strange one.  To accept that China is able to succeed by playing currency games means implicitly rejecting capitalism and embracing the notion that central planning can perform better than free markets.  Accepting this proposition also means accepting conventional wisdom as fact rather than looking at the data.  The realities of the modern world simply prevent China from undervaluing their currency in the way critics claim.

To understand why, we need to remember the basics of economics.  The price of a good increases when demand increases and decreases when supply increases.  This is true for money just as it is for gold, wheat, cars or any other scarce good.  If government attempts to subvert the laws of economics by setting price controls, then shortages or gluts result.  The classic example of a shortage would be the long gas lines created by Jimmy Carter’s energy price controls.

Money gluts and shortages operate a little differently and can be understood by applying Gresham’s Law.  Let’s say, for instance, that the Chinese central bank (the People’s Bank of China or PBC) undervalues the Yuan at an exchange rate of 10 yuan to 1 US dollar, but the market value is actually 7 to 1.  Seeing a mismatch between the official price and the market price, investors will want to buy yuan from the PBC to sell on the market.  When enough investors notice the mismatch, this becomes a sort of bank run.

When the PBC runs out of money, they have choices to make.  They can refuse to convert Dollars for Yuan, in which case the peg is effectively broken.  They can print more yuan to exchange for dollars, increasing the supply of yuan until the market value drops to match their official value.  Another option, related to the previous one, is to print more yuan, exchanging those yuan for dollars and then sitting on their dollar reserves.  This increases the value of the dollar by making dollars more scarce while simultaneously make yuan less scarce.

The final option is the one that China has effectively followed.  Notice, though, that what they are doing relies on market forces.  The market still determines the value of the Chinese currency rather than government fiat.  Had China not backed their peg with monetary policy, the peg would have been broken.  While China can affect exchange rates, they cannot undervalue their currency in the sense of declaring a value other than the market value to be the official value of the yuan.

Gresham’s Law -- the economic principle which explains China’s and other countries’ monetary policy misadventures -- is usually stated as “bad money drives out good.”  A better formulation is, “bad money drives out good when the exchange rate is set by law.”  As seen with the above example, the Gresham’s law can manifest itself in different ways -- especially when you are dealing with fiat rather than commodity backed currencies.

One important caveat must be added.  If the Chinese were to declare an official that was close but not identical to the market value, this would not necessarily cause a run on their currency.  Doing business with the People’s Bank of China has certain transaction costs.  For a black or grey market to arise that could create a run on the bank, the margin must be large and dependable enough to invest in yuan (or dollars) to sell to the Chinese central bank.

This raises the question of whether the facts support the theory.  Historically, we know that currency black markets do pop up when countries attempt to manipulate their currency by fiat.  Hugo Chavez’s Venezuela comes to mind, as does East Germany.  Both of these examples are of over-valuing currency, but it demonstrates the principle that the market finds a way around official exchange rates.  So, if China cannot manipulate its currency by fiat, has it been flooding the market with Yuan so as to reduce its currency’s market value?

Looking at the past decade, we can divide the data into four periods.  From 1997 to 2005, the Chinese pegged their currency at an official rate.  From 2005 to 2008, the Chinese allowed the Yuan to appreciate against the Dollar by almost precisely 20%.  From 2008 to to 2010, China maintained a pseudo-peg of the yuan to the dollar where monetary policy was used to maintain a rough balance.  Then, from mid-2010 to present, the Chinese have simply allowed the Yuan to rise naturally as the United States has embarked on a series of misguided efforts to stimulate the economy by injecting liquidity into the market -- i.e. by printing money.

Comparing the peg era and the pseudo-peg era is informative.  When China established an official peg, they were converting currency at the declared rate.  This rate had to close enough to the market value as to not cause a run.  The official peg was not identical to the market value -- see the 2% jump in the yuan’s value following the removal of the peg -- but it was close enough that they could compete in the market given transaction costs.

The evidence also demonstrates that Chinese did not need an official peg to maintain a stable exchange rate with the dollar.  In the pseudo-peg era, China (as well as Japan and other countries) busily bought up US treasuries and dollars in order to maintain the peg.  It was only successive waves of foolhardy quantitative easing by the Federal Reserve -- the US central bank -- that convinced the Chinese to completely sever the relationship between the Dollar and the Yuan.

It is also instructive to look at the chart of the two unpegged eras.  The first shows a controlled slide of the dollar against the yuan.  It is so controlled in fact, that it resembles a geometric curve.  The slide accelerates until coming to an abrupt halt.

In the second unpegged era, we see China throwing up its hands.  The yuan is increasing in value relative to the dollar, but the PCB is no longer able or willing (or perhaps both) to manipulate the exchange rate as precisely as before.

The evidence also dispels the theory that China is devaluing their currency in order to gain a competitive advantage.  At no time during the past decade did China drop the value of their currency.  During the two unpegged eras, the value of the Yuan rose significantly, just as critics demanded.  Critics insisted that China allow its currency to appreciate by 20-40%, and so fair the Yuan has appreciated by roughly 30% against the Dollar.  If earlier Chinese currency devaluation helped China jump-start their manufacturing sector, we would have expected US currency devaluation to do the same for the United States.  Instead, unemployment remains above 9% and nobody is discussing an American manufacturing renaissance.

In short, the discussion of Chinese currency manipulation is a pointless distraction.  Despite the fantasies of central planners throughout history, the market always prevails.  The Soviets could not effectively set the price of milk, and Chinese cannot set the price of money.  The laws of supply and demand will not be repealed.  Let us rise above our competition by renewing our commitment to capitalism and freedom.