Contrary to the phrasing of many news accounts, China is not devaluing its currency. The value of the yuan relative to the dollar is indeed declining, but the Chinese central bank is intervening in foreign exchange markets to limit that slide. To do so, it must sell dollars; and to have dollars to offer, it has to sell off the U.S. Treasury bonds it has been holding.
Often predicted by naive catastrophists in apocalyptic terms — China demands all its money back in one day, and the U.S. and world economies collapse — the reality seems much more benign. The Chinese have cashed in a tenth of their dollar holdings in the past three months, and effects on the U.S. are barely perceptible. Still, this selloff of U.S. bonds into world markets — rather than a Chinese premier slamming a dun notice down on President Barack Obama’s desk — may become the dominant factor in the economic history of 2016.
And, depending on how things play out over there, it could become the most important news story this year, touching everything: the presidential election, the stock market, jobs and inflation.
The Chinese government’s attempts to stabilize its economy, particularly as it stops lending money to fund U.S. federal budget deficits, will affect the U.S. economy overall — and individual households. One immediate result is that it further complicates the U.S. Federal Reserve’s task of choosing the best monetary policy.
Let’s start with some terms and recent history. While economic journalists and some economists use the terms “devalue” and “depreciate” interchangeably in regard to exchange values, there is a difference. A devaluation is when a country has an official fixed exchange rate relative to some other country and makes an overt decision to lower that value. The exchange rate moves from one official rate to a newer low one.
Depreciation of a currency’s value occurs when the exchange rate is not fixed, but rather fluctuates with market forces of those who have the currency and want to sell it versus those wanting to buy. In other words, supply and demand. When this market price declines, i.e., it takes fewer dollars to buy a yuan, the currency has depreciated. When the converse is true and it takes fewer yuan to buy a dollar, the currency has appreciated.
For the 10 years leading up to 2005, China had a true fixed exchange rate. Over 10 years, the rate never varied outside of a narrow band around 8.3 yuan per dollar. But in June 2005, bowing to diplomatic pressure and market forces, the Chinese central bank moved to a “crawling peg” system and let its currency’s value grow.
On any given day, an official rate was set by the central bank. But that rate moved frequently, so that by 2008, the yuan had increased in value such that only seven were needed to buy a dollar. By 2014, it took only six. One could say the yuan had gained value or that the dollar had lost value.
The upshot here was that for any given price of Idaho-grown seed potatoes or Boise-made commuter locomotives, the price to a Chinese buyer had decreased by 27 percent from 2005 to 2014. For a U.S. retailer such as Target or Walmart, the U.S. currency cost of a yuan had gone from 12 to 16.5 cents, an increase of 37 percent. U.S. exports to China had gotten cheaper in that country. Imports from China had gotten more expensive here.
To counter these effects, the Chinese are often accused of manipulating their currency to keep its value low relative to the dollar. Indeed, I have said that in several columns over the past 16 years. In doing so, it emulated Japan’s policy from 1954 on and the policies of “Asian Tigers” such as Korea, Taiwan, Hong Kong and Singapore.
A central bank keeps a currency cheap by creating enough new money so that it can buy up as many dollars in the market as needed to keep their price high — lowering supply, if you will. It is a loose monetary policy focused on foreign exchange markets rather than domestic credit.
Because this involves buying up many dollars and other foreign currencies, China’s central bank must decide how to hold these. U.S. Treasury bonds are a safe investment. That is how China ended up holding a large fraction of the U.S. national debt early in the new millennium.
At a practical level, there is little difference between goosing the money supply to keep a currency cheap, and hence exports high, and goosing it to stimulate a flagging economy through ample credit and low interest rates, as the Fed has done. To argue, as former Fed Chairman Ben Bernanke has, that the U.S. was not manipulating the exchange value of the dollar because that was not the primary aim of “quantitative easing” is cheap sophistry. The actions and their effects are the same.
In any case, the value of the yuan rose steadily against the U.S. dollar for nearly nine years, 2005-2014. But its value since 2014 has slid so that it takes 10 percent more yuan to buy a dollar than two years ago. That is what many now describe as “devaluation.” This slip in value is mostly against the dollar. Against the Japanese yen, the euro and currencies of other nations with which it trades, the decline in value of the Chinese currency is much smaller.
The use of the term “devalue” implies that this is China’s objective. Yet while the yuan has declined in price since 2014, China’s central bank has been selling dollars like crazy to buy up surplus yuan. China burned through more than $100 billion in foreign currencies doing this in the month of December alone and over a half trillion in 2015.
China is in a terrible bind. As with Mexico in its crises of the 1980s and 1990s, its own citizens are heading for the door first. Anxious to get their money out of China before its economy tanks, wealthy Chinese households and companies are trading yuan for dollars. This drives the market value of the yuan down and that of the dollar up.
Let that happen uncontrolled, and panic will set in, with even more people wanting to get through the door before foreign currencies get even more expensive. Try to stem it and fail and you get the same panicked result. Stem the flow only by burning through reserves of foreign currency and you advertise to the whole world that fear is afoot.
Chinese officials are resorting to bluster, with officials quoted in the Wall Street Journal and elsewhere this week saying that rumors the yuan will depreciate another 10 percent are “ridiculous and impossible.” Don’t bet on it.
The remarkable thing so far is that China has managed to sell lots of Treasuries without notably depressing the price of these securities. That would drive up dollar interest rates without any action by the Fed. The dollar may continue desirable only as “the least ugly nag in the glue factory,” but as long as others prefer dollars to its alternatives, there will be demand for dollar-denominated securities like U.S. Treasury bonds. But Fed policy makers cannot count on this remaining true forever.
Official bravado aside, don’t be surprised if the yuan continues to cheapen relative to the dollar. That is too bad for U.S. farmers and manufacturers. But there is not much we can do about it. Hope — nay, pray — that fear does not become panic, creating a true classic foreign exchange crisis for China this year. That is the last thing the global economy needs in 2016. But the probability of it happening is there.
St. Paul economist and writer Edward Lotterman can be reached at email@example.com.