Economic Reasons Why the Yuan Must Appreciate

Monday, December 31, 2007

The article, China Lets Currency Appreciate a Bit Faster,” was published in the New York Times on December 29, 2007.

Quote from the article:China’s currency rose steeply against the dollar this week, feeding speculation that Chinese authorities, yielding to international pressure and economic realities at home, were allowing their currency to appreciate more rapidly.”

My opinion: China is not yielding to international pressures; they can no longer maintain the peg against a basket of currencies.

The Chinese People’s Bank of China has maintained a peg to a basket of currencies, including the US dollar, since 2005. A peg is a value of the currency (the Chines yuan, also referred to as the renminbi) chosen the the central bank (in this case, the Chinese People’s Bank of China). The central bank maintains the peg by buying international currency on the open market. Since 2005, the value of the Yuan has been roughly 8.11 Yuan/U.S. dollar. Today, the value of the Yuan is 7.30 Yuan/U.S. dollar –the U.S. dollar depreciated, while the yuan appreciated.

Why might this happen? According to the NY Times, the Chinese government bowed to international pressures and allowed the yuan to appreciate in order to curb exports to countries such as the U.S. While this is likely a small part of the reason, I see three reasons that are much more prominent.

First, and foremost, the People’s Bank of China holds more than $1.2 trillion in foreign exchange reserves – a level that is very costly. The reserve stock is denominated in currencies such as the euro, British pound, South Korean won, Japanese yen, Thai bhat, Russian ruble, Australian dollar, Canadian dollar, and the Singapore dollar. The largest share of currency in the foreign exchange reserves, however, still goes to the U.S. dollar. How big is $1.2 trillion? That is more than 1/10 of China’s total GDP in 2006. What does the People’s Bank of China do with such a large stockpile of reserves? Up until now, they have been simply sitting on the reserves and earning a low or no return on the portfolio – maintaining the peg with ease. Now, they realize that it is becoming too costly to stockpile the reserves, and not seek alternative investments that yield a higher expected return. According to the McKinsey Global Institute, the People’s Bank of China is losing 1.9% of gross income annually (based on 2006 gross income) by not investing the excess currency. That is a large number for a country’s whose gross income in 2006 was $10.17 trillion (measured in U.S. dollars).

Second, China is growing quickly, incurring the costs of high inflation (percentage change of rising prices). By maintaining the peg, Chinese inflation is in double-digits; export growth is so strong that prices are beginning to rise uncontrollably. One way to curb inflation is to allow the currency to appreciate a bit. High export demand from key countries, such as the U.S. and Europe, may fall, pulling down inflation in China.

Third, China lacks the ability to control economic conditions through monetary policy; the People’s Bank of China’s only current coal is to maintain the peg, not to influence the domestic economy. An example illustrates my point using the U.S. central bank, the Federal Reserve Bank. The primary goal of the Federal Reserve Bank is to maintain stable prices and stimulate growth to its potential level. If prices are rising too quickly, then the Federal Reserve Bank has the option to raise the federal funds rate in hopes of curbing price increases. The People’s Bank of China (the monetary authority in China) cannot do this – by maintaining the peg, they essentially lose control of economic objectives such as curbing prices. Controlling economic conditions is left to the other side of the government (the fiscal sector). So, by allowing the Yuan to appreciate, China gains some control of the economy by using monetary policy. Eventually, China will need to have a completely functioning monetary sector (the People’s Bank of China) to take advantage of economic objectives, such as stable prices.

In conclusion, there are three important reasons that the People’s Bank of China is forced to allow the yuan to appreciate. They are: an ever-growing stockpile of foreign exchange reserves, inflation, and attempt to gain monetary control - not international pressures.

This is not the end in the appreciation of the yuan. Economic forces will eventually force the yuan to exhibit characteristics closer to a floating currency (such as the U.S. dollar). Don’t be surprised if this happens over the next five years!

Do you have any comments? I welcome your input. Nontruths


Anonymous April 24, 2008 at 4:22 AM  

What about Yuan's depreciation against euro? This is the most confusing part.

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