China’s currency policy: avoiding a Japan-style bubble (and bust)?

October 4, 2010

Popular economic opinion believes that China’s currency, the RMB, is undervalued when compared to the US dollar. Many believe that China is practicing unfair protectionist policies by artificially suppressing the RMB (or artificially inflating the dollar — depends how you look at it), by selling RMB and buying up the surplus dollars that flow to China’s shores as the result of its large trade imbalance with the US.

Most economists believe China is doing this to avoid weakening its export industry. The classical economic argument goes (with balance-of-payment accounting identities and all) that a trade surplus naturally leads to a relatively strengthening currency, compared to the trading partner, as the trading partner demands more of that currency to purchase the surplus imports. Conversely, the trading partner’s deficit naturally causes its currency to depreciate, as less currency is demanded by the surplus nation (relatively) to clear the trade. As the exchange rate shifts, it becomes more expensive for the deficit partner to purchase the surplus partner’s goods, while it becomes less expensive for the surplus partner to purchase the deficit partner’s goods. The demand curve tells us that as costs rise, demand decreases, and as costs fall, demand increases. Eventually the imbalanced demand between the two nations evens out; and thus, so does the trade imbalance.

For the surplus nation, this generally means less (foreign) demand for its products. Lowered demand could result in higher unemployment. So, it is reasoned, China is suppressing its currency to avoid higher unemployment in its export industry, by maintaining its large trade surplus over the US, and keeping its products nice and cheap for American consumers.

Paul Krugman makes this point in a recent column:

(The Chinese) deny that they are deliberately manipulating their exchange rate; I guess the tooth fairy purchased $2.4 trillion in foreign currency and put it on their pillows while they were sleeping. Anyway, say prominent Chinese figures, it doesn’t matter; the renminbi has nothing to do with China’s trade surplus. Yet this week China’s premier cried woe over the prospect of a stronger currency, declaring, “We cannot imagine how many Chinese factories will go bankrupt, how many Chinese workers will lose their jobs.” Well, either the renminbi’s value matters, or it doesn’t — they can’t have it both ways.

(Krugman doesn’t clearly state which way HE has it. But he does think the US should get tough with China over its currency manipulation.)

Avoiding currency speculation

There may be another reason why China does not want to let its currency appreciate — it may be afraid of currency speculators. Michael Hudson points out that China-US relations today are similar to Japan-US relations in the 1980s. Japan ran a consistent trade surplus over the US. To combat the issue, Japan and the US and other nations signed the Plaza Accord — a plan to allow the yen (and other currencies) to appreciate against the dollar, in order to even out trade imbalances. Hudson believes this plan contributed to Japan’s massive asset bubbles of the late 1980s:

This attitude is sweeping Congress, whose China bashing is reminiscent of the Japan-phobia of the late 1980s. This ended when the United States convinced the Bank of Japan to commit financial suicide by agreeing to the Plaza and Louvre Accords turning Japan into a bubble economy by raising the yen’s exchange rate after 1985 and then flooding the economy with credit.

In today’s replay, U.S. strategists would not mind seeing China’s economy similarly untracked by letting global speculators bid up the renminbi’s exchange rate – by enough to let Wall Street speculators make hundreds of billions of dollars betting on the run-up. “Free capital markets” and “open financial markets” are euphemisms for setting the renminbi’s exchange rate by the pace of U.S. and European currency arbitrage and capital flight. The U.S. balance-of-payments outflow would increase rather than shrink, thanks to the ability of American banks to create nearly “free” credit on their keyboards to convert into Chinese or other currencies, gold or other speculative vehicles that look to rise against the dollar.

Hudson argues with some contemptuous zest, but he may have a point. Looking at charts of the Nikkei index and the Japanese housing bubble, it does seem that the timing of the Plaza accord (1985) coincides with sudden bursts of growth in both bubbles (yes — correlation is not necessarily causation, but the evidence here is strongly suggestive).

Was this the work of currency speculators? Could be. A currency speculator would purchase the appreciating currency with the intention of selling it later at a better exchange rate. In the meantime, he needs a place to put the money. The foreign currency is only good for buying assets in the foreign country. So it makes sense that a lot of the money would go into the Nikkei or into Japanese real estate or Japanese bank bonds. All those assets were rising, which meant an even better return on the currency bet, once the appreciation is factored in.

If China believes that the Japanese economy was destroyed by a huge wave of currency speculators, then it makes sense that it would try to maintain a stable exchange rate. And even if China did intend to allow the RMB to appreciate, it certainly isn’t going to telegraph that policy to the market — lest it open the speculative floodgates.

Which leads me to another thought: specifically, the swift and effortless and instant speculative flow of capital across the globe in today’s tech-modern market, and what kind of effect that has on global economic stability. But that’s another thought for another day…

UPDATE: Paul Krugman points out that China has capital controls, which prevent foreigners from purchasing any signifcant yuan assets. This would seemingly prevent the kind of currency-speculation bubble I’ve outlined here.

UPDATE’: Whatever those capital controls are, they apparently can’t stop significant gains in foreign direct investment.


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