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The US Dollar v. the Chinese Yuan: There's More than Meets the Eye

A great deal has been written about the Chinese economy -- much of it nonsense -- and the pegging of the yuan to the US dollar. I think a little theoretical digression may be in order. If the world were on a gold standard, by that I mean that all notes and bank deposits would be supported by a 100 per cent gold reserve, the pegging of currencies would not be possible. Each currency would represent a certain amount of gold. If currency A represented x gold units and currency B represented 2x units of gold then the exchange rate would obviously be 2:1. There would be no inflows or outflows of any significance so long as the exchange rates stayed with the gold points1.

The classical theory held that gold flows brought about changes in price levels which in turn would restore the exchange rate. Yet it was discovered that exports and imports corrected themselves without any change in relative prices, meaning that international gold movements did not take place according to the theory. It was then determined that if a country's export income increased, the resulting rise in domestic incomes would increase imports without any change in the price level and therefore in gold movements. (This is sometimes called the theory of transfer).

Clearly such a monetary system would be self-regulating2. But as soon as the world moves on to a paper standard (sometimes called a managed currency) the situation becomes one of indeterminacy, by this I mean that there is no built-in governor regulating the value and flow of currencies. Once this happens it opens the door to all kinds of monetary shenanigans.

This brings us to China's dollar peg. The Fed's loose monetary policy has succeeded in driving down the dollar with respect to many other currencies, particularly the Euro. Yet the yuan is still linked to the dollar despite China's aggressive monetary expansion. How can this be? Surely the dollar depreciation should have broken the peg and forced the yuan to appreciate? Well, like all things economic, we have been there before. The inter-war years saw a great deal of currency manipulation (the Nazi manipulation of the mark was a wonder to behold) to the extent that Gottfried Haberler observed:

The experience of recent years shows that it is possible, to a quite unexpected extent, to isolate ... one country's price-levels from those of the outside world and thus to maintain for a long period an exchange rate which is quite out of line with purchasing power parity in the ordinary sense. (Gottfried Haberler The Theory of Free Trade, William Hodge and Company LTD, 1950, p. 38, first published in 1933).

Manipulating currencies is not a costless exercise, far from it. To prevent the yuan appreciating against the dollar China's central bank (People's Bank of China) has to print more and more yuan with which to buy dollars. While this has been going on domestic credit expansion has reached dangerous levels. M2, currency and credit has been racing ahead at more than 17 per cent a year. This is akin to a runaway monetary train. Not surprisingly, manufacturing investment, real estate and the stock market are booming. Since last year alone the Shanghai stock market index has rocketed by more than 300 per cent. This has all the earmarks of a classic boom.

The PBOC is certainly not blasé about the situation. It has raised interest rates four times this year, with the one-year rate now standing at 7.02 per cent. These increases have not even dented the boom. This has led the PBOC to make noises about further interest rate hikes. It can make all the noises it likes, but this monetary-driven boom is going to require a little more fortitude on the part of the bank. The problem is not a purely monetary one. There is the vital question of the capital structure to be taken into account, a question that will have to be left for another article. Suffice to say for now that the distortions caused by a reckless monetary policy will require painful adjustments.

Wu Xiaoling, deputy governor of the People's Bank of China, is reported to have said that it might take a year or so to determine whether interest rates are negative. This is a damning indictment of the PBOC's monetary policy and clearly indicates that interest rates have a long way to go before they puncture the boom. There is some talk of applying more aggressive open market operations to reign in liquidity. If the PBOC wants to squeeze liquidity then it must put an end to monetary expansion. If it fails to do so then eventually real factors will operate do the job for it.

In the meantime, minor changes to the dollar-yuan exchange rate are not going to make much of a difference. Monetary policy has been slowly tightening in the US. There is always a lag between changes in monetary policy and output and prices. But there is also the exchange rate. The dollar could stabilize while the yuan continues to inflate. The US could then find itself in a position where the yuan starts falling against the dollar.

All we can say with certainty is that a world in which currencies are at the mercy of central banks is one in which predictions of exchange rate movements can be akin to gambling.

1. Gold points are the upper and lower limits that regulate the flow of gold and are set by transport costs. If the value of gold in once country rises above the gold import point then gold will be imported. Should the value of gold fall below the export point then gold will be shipped out.

2. It was a quasi-gold standard in the sense that gold was held as a fractional reserve against the total supply of notes and bank deposits. According to Jacob Viner between 1850-1890 the gold reserves of the English banking system never exceeded 4 per cent. (Jacob Viner Studies in the Theory of International Trade, Harper and Brothers Publishers, 1937, p. 264).


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