"The Buck Stops... in China." : Investigating China's confusing monetary policy

What is up with China's currency and monetary policy, and what's the deal with their stockpile of American assets?

Here's an explanation of why I have recently become so determined to understand this. On Tuesday morning at the Circ. Desk, Sandy came up to me, cited how I intend to major in economics, and asked me some questions about China's possession of American assets - why they have them, what they might do with them, what the effect of the current recession has been on their value, etc:

Sandy: "... so I'm only asking this because I figure you're interested in this stuff. But I read this article in The Economist, "The Danger of the Bounce", .... do you know why China ...?"

Martha: "Yeah, um... hmm. I don't know much about that. I guess they wouldn't want to convert all their assets to their own currency..."

Sandy: "Yeah, because they don't want it to depreciate... inflation..."

Martha:"But I do remember learning about how China wanted to keep its currency worth little compared to the dollar so that their goods would be cheap for American buyers... So, yeah, I don't really know about that..."

Meanwhile, Julie, a senior economics major was sitting next to me.

Julie: "...it wouldn't really matter. They could always exchange the assets back to their own currency..." Later, in response to my vague memory of China wanting its currency worth little: "I don't understand why they would do that... it would hurt their people to make their money worth less than would it should be..."

So, after that conversation revealed my ignorance on the issue, I decided that I would figure out what the heck China was up to even if it meant applying structured procrastination at 1:02 AM.

Here is a summary of my path to a limited understanding:

After Wikipedia strangely failed in giving me an elementary understanding of the situation, I searched Google, and found this discussion titled "Can you explain the dispute over Chinese currency valuation?" In it, one response cited a paragraph from a May 2007 Fortune Magazine article, "China's $1.2 Trillion Cash Hoard" (a great title):

Beijing's burgeoning foreign-cash pile is a consequence of its effort to boost exports by fixing the value of its currency, the yuan, to the U.S. dollar. To keep the yuan from appreciating too quickly, the central bank buys up dollars brought to China by foreign investors and Chinese exporters. Then the bank issues bonds to mop up the yuan it has paid for those dollars, thus warding off inflation.

The guy who posted that followed it with refreshing honesty: "Hopefully Fortune isn't just making it up because I sure wouldn't know the difference." Haha, I feel you, Stuart S.

So the paragraph confirms my previous understanding that China tries to keep its currency somehow 'undervalued' so that its goods are cheaper for other countries, especially the US, to import. Chinese leaders want to keep their exporters ultra-competitive in the world market, because: 1. It grows the infrastructure of China's economy, and there is a lot of room for it to grow; 2. China has a huge population willing to work for long hours in factories. The export industry ensures their easy employment; and 3. They know that we Americans have a lot of wealth that we are willing to expend for cheap goods.

Now the question is: how does pegging the yuan to the dollar magically make their goods cheaper to us? If there are 6 yuan to the dollar, and a camera costs $100 in the US, wouldn't the same camera cost 600 yuan in China, and therefore cost the same $100 for us to purchase there (after we exchange our $100 to 600 yuan)?

As it turns out, the answer to that is 'No.' And this is where Wikipedia did help me out, by referencing Purchasing Power Parity in the article on renminbi. Wikipedia defines PPP as a tool for comparing between countries "the amount of a certain basket of basic goods that can be bought in the given country with the money it produces" (The Economist got witty with PPP in 1998, comparing the relative prices of Big Macs in different countries: "Big MacCurrencies").

Good old Wikipedia even uses the Chinese economy as an example. Apparently, in 2003, the basic good that cost $1 in the US cost 1.8 yuan in China, so the PPP of China to the US was 1.8. However, at the same time, due largely to China's pegging strategy, $1 was trading in the money market for 7.6 yuan. So, the yuan being worth less on the world market didn't mean that it was worth that much less in its own markets, which explains China's incentive to peg their currency at 7-8 yuan to the dollar, and answers Julie's concern over why Chinese leaders would hurt their own people by devaluing their currency.

Because of the way international commerce works PPP doesn't automatically adjust itself to exchange rate (on this note, Wikipedia mentions the "law of one price", its rejection by econometric analysis, and something called the "Balassa-Samuelson effect theory"). Although the US is getting an amazing deal when it purchases goods from China at 'artificially low' rates, it doesn't necessarily mean that the Chinese are getting a bad deal. As the paragraph from Fortune states, the Chinese "bank buys up [the] dollars brought to China by foreign investors and exporters", thus returning payment and wages to Chinese workers in yuan, which they will sensibly use to buy in their domestic market, assisting the Chinese economy even further.

With the export market and domestic demand booming, the only problem Chinese leaders have left to worry about is inflation, which, again according to Fortune, is a problem monetary authorities solve by selling bonds to "mop up the yuan".

Now what on earth is happening with China's stockpile of American assets, or as the 2007 Fortune article put it, with their "trillion dollar cash hoard"? Well according to another brilliant article I just found from the Jan/Feb 2008 issue of The Atlantic, "The $1.4 Trillion Question", written by James Fallows, China's cash hoard, represents, in effect, the savings of the Chinese taken by their government and invested in the United States:

Through the quarter-century in which China has been opening to world trade, Chinese leaders have deliberately held down living standards for their own people and propped them up in the United States. This is the real meaning of the vast trade surplus—$1.4 trillion and counting, going up by about $1 billion per day—that the Chinese government has mostly parked in U.S. Treasury notes. In effect, every person in the (rich) United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People’s Republic of China...

Any economist will say that Americans have been living better than they should—which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.

How exactly has Chinese government "held down the living standards for their own people"? Fallows explains that too. When Chinese producers trade goods for dollars, they bring those dollars to a Chinese bank, which, under China's "surrender requirements", surrenders the valuable dollars to China's central bank, which then cranks out renminbi at the 'official exchange rate'. In other words, China's government takes the hard-earned dollars that are guaranteed value in the international market, and gives back to its people a currency whose value they have complete and utter control over. The result, as Fallows states, is "to keep the buying power earned through China’s exports out of the hands of Chinese consumers as a whole".

China has traditionally invested most of its dollar hoard in US Treasury bills, which are known for their "boring safety", earning a guaranteed but very low rate of interest which has barely kept up with the devaluation of the dollar against the renminbi in recent years. That's why, with the value of the dollar continuing to drop, China fears that its hoard is losing too much value and America fears that its biggest investor may drop the ball.

These days, although the Chinese are certainly looking for more profitable areas to invest their dollars, even researching how major American university manage their endowments, they have every incentive to hold onto the ball as tightly as possible while they move around the court. If they made any move that signaled a loss of faith in the value of the dollar, the world would notice: "Their years of national savings are held in the same dollars that would be ruined; in a panic, they’d get only a small share out before the value fell. Besides, their factories depend on customers with dollars to spend." This is a great example of how market incentives naturally encourage actions that benefit everyone. China truly is invested in American interests, so we need not worry all that much.