“Why is the president upset that China is giving Americans a deal?”
By David Riccione
Most people are familiar with the fact that the Chinese government often intervenes in currency markets to peg its currency, the renminbi (RMB), to the US Dollar (USD). The concept is highly politicized, especially in the United States, where often politicians, like our current president, are quoted for blaming China’s currency intervention as one of the driving forces behind the imbalance of trade between the United States and the Middle Kingdom (which doesn’t really make sense as the Chinese government has been artificially strengthening their currency, not devaluing it, but I digress).
These claims are what usually come to mind to most Americans when we mention “Chinese currency manipulation,” but what doesn’t come to mind is that the moving peg approach to currency value, the mechanism China has employed, is widely used by other governments. Ironically, the practice has led to serious negative consequences for China as well. This article will examine China’s employment of capital controls and other monetary policies to manage its currency value to the dollar, the consequences of such especially as they relate to internal domestic investment, how the US may actually be benefited, and the forward-looking situation.
Renminbi to Dollars: A Moving Peg
Governments have a number of options to choose from regarding foreign exchange policy. For many western developed nations, the policy is usually to have no policy at all, but rather to let the domestic currency “float” naturally in currency markets. This of course leaves the currency value to be chosen by market forces, sometimes resulting in volatility. Conversely, the extreme opposite of said policy would be to totally fix one’s currency to another currency (usually the dollar) or a basket of currencies, which often involves monetary authorities intervening to keep currency values within a prescribed band. China, our case study, has picked a policy somewhere in the middle and called it the moving peg approach.
The Chinese government in 1995 chose to fix its currency to the US Dollar at 8 renminbi per dollar in an attempt to bring increased economic stability, and improve expectations for international traders (they effectively eliminated foreign exchange exposure). That fixed exchange rate held until 2005, when the government reversed policy, allowing for slight liberalization with a mild trading ban of plus or minus 2%.
The RMB faced heavy appreciation pressure until 2015, and accordingly the Chinese government began accumulating large reserves of USD in an attempt to limit the currency from gaining strength above the peg. However, after 2015, the authorities effectively moved the previously set peg as trends reversed, and depreciation pressures to the USD set in. Accordingly, the government allowed for greater devaluation of the renminbi, and since then has allowed for gradual depreciation (the peg has been moving).
Natural market forces, however, would demand much higher depreciation to the dollar than that experienced today, mostly driven by the surging dollar value, among other variables. Indeed, the Chinese government has been burning through its dollar reserves to ease its currency depreciation by buying RMB in international markets to keep demand high (and accordingly currency value high). Reuters found that in 2016 alone, Chinese reserves of US dollars fell by $320 billion, to just over $3 trillion total from nearly $4 trillion a year previous, with little expectation of slowing.
In an attempt to mitigate the hemorrhaging, the Chinese government accordingly began increasing its already powerful capital controls. The Chinese government, using both direct and de facto methods, has restricted Chinese nationals from buying international assets to reduce the supply of RMB in the market. Admittedly, the strategy has been quite effective, and according to Reuters, outbound direct investments fell by almost 36% to $7.77 billion, its lowest in a year and a half.
Current Accounts Effects
One of the biggest promises set forth to the American people by the president during the last election cycle was to label China as a currency manipulator by the US Treasury Department. President Trump, at the time, claimed that Chinese currency manipulation was a leading factor in stealing American jobs, with emphasis on the manufacturing sector. This claim is objectively incorrect if one analyzes Chinese currency policy since 2015, and in fact current Chinese forex intervention has probably helped the American macro economy.
For the last few years, the USD has gained tremendous strength against most currencies, the RMB included. As the USD has gained momentum, it has become more expensive for internationals to buy USD denominated assets, like US manufactured cars, or vacations in US cities, etc. This of course means that US net exports have faced material downward pressure from said foreign exchange trends, and one can certainly expect that to continue as it becomes costlier for internationals to buy American. GDP is a function of domestic consumption, government consumption, planned investment spending, and net exports – so when net exports fall, so too does our nation’s gross domestic product (meaning we all get less of what we want).
The RMB is no exception of currencies that are losing value to the dollar. As mentioned before, the currency should probably be losing much more value than has been realized. This if of course because the Chinese government’s moving peg approach is quite averse to large swings in value, and accordingly it has been buying RMBs with its dollar reserves. But if it didn’t do this, the RMB would be much weaker to the dollar, giving the US a clear forex trading advantage, as it would be much cheaper for Americans to buy RMB denominated assets (like everything manufactured in China), and much more expensive for Chinese to buy American denominated assets.
Based on this understanding of international economics, the Chinese government has actually been helping balance the current trade relationship with the US. In fact, buy keeping the RMB artificially strong, they make it less appealing for US consumers to buy Chinese products, and more appealing for Chinese to buy American. Pursuant to this fact, one should wonder why the president is upset that China is giving Americans a deal.
What have the effects of slowing the depreciation of the RMB been on the currency’s host country aside from the previously discussed trade effects? The capital controls the Chinese government has placed on its citizens creates a very real opportunity cost for Chinese investors seeking yield outside of China. The fact that Chinese investors could probably find better opportunities to employ their capital abroad, garnering them a high return, but can’t because the government limits the quantity of investments they can make outside of China, means an entire nation is making less money from their investments than is possible.
To forward this idea, capital controls don’t just mean that Chinese investors are being forced to return, say 3% instead of 5% they could have returned from a dollar denominated asset, but it also means that a project in China was financed artificially which may not have been financed under free market conditions. This creates a serious distortion in financial markets, where projects that have an internal rate of return too low to be financed under normal conditions, are financed anyway because investors need to place their money somewhere, and if they can’t invest in the efficient project abroad, they are forced to finance the less efficient project domestically. We saw how the Chinese investor lost out with lower yields, but of course the global economy loses out too, as good projects that deserve capital don’t get it because the Chinese government wouldn’t allow it to be financed.
This phenomenon is one of the reasons were are seeing massive bubbles forming across Chinese asset classes. Chinese investors are not allowed to invest abroad, so far too many projects and investments are being made at home–in turn creating large bubbles. Real estate is the classic example that is cited, where new cities are built in a year with massive residential high rises, with a fraction of the buildings actually inhabited. Last September, Chief Economist at the People’s Bank of China admitted that “Measures should be taken to put a brake on the excessive bubble expansion in the property sector, and we should curb excessive financing into the real estate sector.”
Real estate isn’t the only issue being driven by capital control policies. Financial institutions flooded with savings from Chinese investors are being forced to finance less than credible loans at alarming rates. According to UBS, China’s debt to GDP ratio rose to 277 percent at the end of 2016 from 254 percent the previous year.
But aside from Chinese consumers losing investment opportunities, and financial and real estate bubble worries, there are also direct costs of capital controls the China faces. The Chinese government, and ultimately its taxpayers, are forced to commit considerable resources to regulate international trade and financial activity to maintain the capital controls.
Control has become increasingly difficult, especially as Chinese investors and businesses have a growing incentive to invest abroad as yields in the homeland are relatively weak. This might be best evidenced by the smuggling of goods and currency into Hong Kong from the mainland, as Hong Kong is generally the gateway to global investment for most Chinese. According to the Financial Times, “Imports from Hong Kong to China jumped 64 per cent year on year in December, according to China customs data. The same numbers released by Hong Kong customs officials showed just a 0.9 per cent increase, indicating the mainland figures were greatly overvalued.” The disparity illuminates the reality that much is outflowing from China that is unaccounted for.
Not a Bad Deal for Americans
The most explicit benefit to Americans of an artificially strong RMB, and the capital controls which facilitate such strength, is the GDP argument mentioned before. American businesses can be much more competitive if the dollar remains weaker against the RMB than the market would dictate. This keeps net exports unnaturally high in the United States, which consequently keeps GDP unnaturally high – a higher GDP means a higher national income, and that translates to every American having more money to buy the things we love.
Less explicit–though equally as beneficial–are the effects from capital controls on American financial markets. It stands to reason that Americans may be experiencing higher than natural yields from domestic investments than they would if Chinese investors could fairly compete in the market for American financial assets.
This simplifying model should provide a theoretical base for the argument: say the 10-year treasury was the only available security in the United States, which gave a yield of 3%, and the comparable asset in China only yields 2% because of over saturation of domestic investment. Without capital controls, Chinese investors would flood into the 10-year treasury market to capture the higher rate, bidding up the price of the bonds, and consequently driving rates of return down (see basic bond theory for rate and price relationships). With extra competition from Chinese investors for US treasuries, Americans get a lower yield than they would’ve without the extra demand.
This theory can be generalized for most financial assets, and it elucidates how, if correctly applied to reality, the American consumer may be getting a higher yield because of China’s employment of capital controls to keep the RMB stronger.
Now that we know how the Chinese government is intervening in foreign exchange markets to keep their currency stronger to the dollar, how the US may be be benefitting, and how China may be being hurt, what is the forward-looking situation? Will we continue to reap these benefits?
Well, China isn’t just keeping their currency pegged to a single, artificially stronger, exchange rate. They are controlling the dissent of the RMB relative to the dollar. In the short-term situation, I think it’s reasonable to believe that American investment opportunities are lucrative enough that they will continue to attract Chinese demand. Furthermore, a yearning for diversification and higher yields on the part of Chinese consumers will certainly propel them towards USD denominated assets.
Accordingly, the natural supply glut for RMB and the growing demand for USD will probably not stop in the near future, and thus the Chinese government is going to have to continue using capital controls, and allowing their currency to slowly devalue, or face fully burning through their dollar reserves to defend the RMB.
In the long-run, however, I don’t think it’s reasonable to believe the RMB is going to face depreciation pressure, and thus capital controls and market intervention will either cease, or reverse if the government decides to artificially depreciate themselves. This is because, in the long-run, exchange rates are determined by the concept of purchasing power parity. Consequently, if Chinese GDP continue to grow, especially grow faster than American GDP, ceteris paribus, the US will experience fast inflationary pressure, thus driving down the value of the US dollar.
For now though, let’s relax in knowing that Trump’s illustration of a nefariously evil and insidiously cunning Chinese currency manipulator may hold less reality than the rational models indicate.
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