Monday, 17 October 2011

A Chinese currency manipulation primer

Chinese currency manipulation has returned to the business pages and I thought that, before discussing it, a primer on how Chinese currency manipulation actually works would be useful.

China operates without a freely exchangeable currency. Therefore, companies buying goods and services from China must pay in dollars or some other tradable currency.  The Chinese exporter’s bank, having received dollars, must then surrender them to the People’s Bank of China (PBoC) – China’s central bank.

The PBoC receives dollars and converts them into renminbi. Since devaluing the renminbi in 1993, the Chinese have exported about $100 billion more per year than they import (on average). Ordinarily that would mean that selling dollars and buying remninbi, pushes the Chinese currency higher.

But the number of renminbi that the PBoC offers for dollars is determined by their exchange rate policy – not market forces. This means they accumulate excess dollars, which are squirreled away in the State Administration of Foreign Exchange fund (SAFE), while supplying new renminbi that enter circulation in China’s economy.

This has a few implications:
  • First, the PBoC’s release of more renminbi, if left unchecked, means too many renminbi chasing too few goods, causing prices to rise (inflation).
  • Second, because the exchange rate doesn’t appreciate, Chinese goods remain cheap compared to US goods. Conversely, expressed in the deliberately weakened renminbi, any imports are artificially expensive – adding further to inflationary pressure.
  • Third, it leaves the SAFE with a vast sum of dollars to invest – $3.2 trillion as at the end of July. Historically this has been invested in the US treasury market.
Inflation is a big issue for the Chinese as their population spend a high share of their income on food, shelter and energy (non-discretionary items).  The central bank therefore has to find ways to prevent the excess renminbi pushing up prices. Typically the PBoC uses four tools to achieve this, often simultaneously:

1. Raising policy interest rates

Raising interest rates in China discourages borrowers from taking out loans. Unlike developed markets, in China the PBoC mandate two interest rates (one for lending and one for borrowing). Other than that this is basically old-school conventional monetary policy.

2. Changing market interest rates

This is done through what is known as open market operations (OMO). Economists describe OMO as sterilising the new renminbi flowing into the Chinese economy.
If the authorities want to lower interest rates they buy government securities, this pushes the yield they pay down.  If they want to raise interest rates they sell securities allowing the yield to drift higher. The securities’ yield will determine the rate which savers receive. The rate which borrowers pay is basically 3% higher.

If the return achieved on SAFE’s investments (mostly US treasuries) is higher than the interest paid on the securities they sell (Chinese renminbi bills), the monetary authorities realise a profit – in financial jargon this is a carry trade.  As you can see from the chart below, since US interest rates were cut in 2008, China now loses money on these sterilising activities.

3. Raising the bank reserve requirement ratio.  

This restricts the number of loans a bank can advance relative to the deposits they hold.  By raising the bank reserve ratio they restrict credit growth and therefore inflation. 

4. Allowing the exchange rate to appreciate.

Finally the PBoC can restrict inflation by allowing the exchange rate to appreciate. This final tool is the one which is raising protectionist hackles. US policymakers want renminbi appreciation to accelerate.

China is now seeing growth decelerate and so, as Mike has commented, the focus of policy may shift away from fighting inflation and towards protecting jobs (Time for China to weigh in with policy easing). We hope this will be through cuts to interest rate and the reserve ratio requirement, rather than any deceleration of the renminbi’s ascent.


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