China Money 2

I’ve been trying to wrap my head around the arguments about China’s currency control. Before the financial crisis got going, it was fairly easy to understand. China controlled their currency by investing in U.S. Treasury Bonds, which had the effect of keeping U.S. interest rates low. People in the U.S. borrowed money at low rates and spent it in China, encouraging Chinese exports and discouraging U.S. exports. China siphoned off a good chunk of the money through currency controls and sent it back to the U.S. It was a virtuous cycle, except that China kept accumulating bonds.

Back then there were mutterings about the cycle, but nobody really wanted to break it. Things are different now. Interest rates in the U.S. are low, really low. The U.S. no longer needs that Chinese investment to keep interest rates down. Now people are focusing more on the part about exports and imports. As long as China controls their currency, it will be hard for the U.S. to sell into China. Of course, it would be hard anyhow, as the Chinese government controls the Chinese market in many different ways. But making it possible to have competitive prices seems like a necessary first step.

The Chinese government’s controls on currency also have the effect of making their population poorer than they would otherwise be. The money that Chinese workers earn on the world market is not available to them to spend on imports. The government can get away with this because the standard of living is still rising in China, even if it is not rising as fast as it otherwise would. There is a second effect keeping Chinese people from spending on imports, which is that China does not have the social programs that European countries and to a lesser degree the U.S. has. That means that Chinese people save money when they can, because they can not count on getting support later when they need it.

Currency controls are a restraint on free trade, but they are also standard practice for developing countries. It makes sense to use currency controls to encourage people to invest locally and build up local production capabilities. But China is the second largest economy in the world; do they still count as a developing country?

If China lets their currency rise, their exports will inevitably fall. China would risk falling into a local recession. They could use their currency reserves to cushion the bad effects on people, but it would still tend to reduce local manufacturing capabilities. The Chinese government doesn’t want that. The potential gain for China is more abstract: by letting their currency rise, they help the overall global economy, which in turn, eventually, helps China. I don’t know if the Chinese government is prepared to take that sort of short-term risk for long-term gain.

On the U.S. side, the controlled level of the Chinese currency is a trade barrier. This hurts the U.S. in the long term, as it increasingly loses manufacturing capability as people pay artificially low prices to buy goods from China. The U.S. could address this by imposing trade barriers, but that would carry a different long-term cost: U.S. manufacturing capability, protected from direct competition, would become increasingly uncompetitive. The U.S. doesn’t have any good options that I can see.

So it seems to me that the discussions about Chinese currency become pointless. The U.S. has no leverage, and China knows that. China has no incentive to let their currency rise, so they won’t do it. I can see only one way out of this: the U.S. could balance the federal budget and stop selling long-term bonds. That would give China no way to control their currency relative to the dollar, and the currencies would start to move to a more sensible valuation. Unfortunately, U.S. political paralysis makes it impossible to either raise taxes or cut benefits, so this scenario seems unlikely.

Well, there is another way that things could change: the Chinese political system could change. A more democratic government in China would be more responsive to the desires of the Chinese population, and would therefore be less inclined to keep them in relative poverty to keep the export machinery humming. But that scenario also seems quite unlikely.

So things will most likely continue as they have been, to the detriment of people in both the U.S. and China. Unfortunate, but so it goes.


  1. etbe said,

    October 13, 2010 @ 12:14 am

    Surely if China sells the US bonds and diverts the money towards the population then the Chinese residents will buy more goods and services that are provided locally (the language barrier is one factor that reduces their ability to buy services from other countries).

    Exporting stuff to other countries and then investing the money in bonds doesn’t seem to provide a lot of good for the Chinese people.

    Surely having an extra 300,000,000 Chinese people using Chinese manufactured iPads would be better than having 100,000,000 Americans doing so!

    US manufacturing has been in steep decline for a long time. It seems better to have some manufacturing capability remaining due to protection than to have all of it outsourced to other countries.

  2. fche said,

    October 13, 2010 @ 7:12 am

    “The U.S. doesn’t have any good options that I can see.”

    It could get its budget to zero deficit, and start paying down its debt, so that few if any T-bills would need to be issued.

    “A more democratic government in China…”

    Yeah. Compared to communism, “dictatorship of the proletariat” and all, almost anything is more democratic.

  3. jyasskin said,

    October 13, 2010 @ 7:56 am

    The U.S. wants our inflation to be a bit higher at the moment for non-trade reasons. If the Fed accomplished that (see DeLong/Sumner for how that’s hard/doable), the value of the dollar would decline against a bunch of currencies, and China, to keep local inflation low, would likely allow the Renminbi to rise some.

    It seems kind of silly to me to complain of the fact that China controls its currency. The U.S. controls its currency too. The main difference is that China appears to print Renminbi to peg it to our currency, while we appear to print dollars to peg an inflation rate. But China’s inflation rate has been reasonable, so if they were pegging an inflation rate we’d expect to see roughly the same behavior against the dollar.

  4. Simetrical said,

    October 13, 2010 @ 12:42 pm

    How is it that the currency control makes the Chinese poorer? It makes foreign goods more expensive, but it also brings more foreign investment into the country. On the flip side, while it means America has a harder time selling to China, we can buy more easily. If China let its currency rise, it would have more imports but fewer exports, and the rest of the world would have more exports but fewer imports.

    The situation seems fairly symmetric — it’s not obvious to me that raising or lowering currency is either good or bad overall for anyone, overall. This is more or less what at least one economist I follow (Robin Hanson) seems to say, although of course that doesn’t mean other economists agree:

  5. etbe said,

    October 13, 2010 @ 1:02 pm

    Simetrical: How can being unable to spend the money you earn not make you effectively poorer?

  6. jyasskin said,

    October 13, 2010 @ 1:31 pm

    etbe: I’m not sure exactly how China’s currency controls work, so I’ll explain how changes in the value of the dollar would work over here, and maybe someone else can explain how China’s government’s policies mean the same explanation does or doesn’t work over there.

    In the U.S., we have a high dollar, so if you can get a dollar it’ll buy lots of foreign goods. However, it’s hard to export goods, so it’s hard to get a job that’ll earn you that dollar (or the job you do get pays fewer dollars). If we had a low dollar, then a dollar would only buy a few foreign goods, but it’d be easier to get a job to earn dollars (or the job you do get earns more dollars). Overall, I haven’t seen an explanation of which effect is stronger. I assume they’re approximately equal, with perhaps a small imbalance.

    In the short run, wages are sticky and more sticky on the downside, so an increasing dollar is more likely to cause unemployment than lower pay (deflation), while a decreasing dollar will increase employment and then cause jobs to pay more (inflation). In the long run, the employment effect goes away, and you’re left with just changes in the price level.

  7. Ian Lance Taylor said,

    October 14, 2010 @ 9:06 am

    China’s currency controls keep Chinese people poorer because Chinese companies are not permitted to spend the dollars they bring in. Instead, they must send the dollars to a couple of government controlled institutions, which will return renminbi at a government set rate. Because the government rate keeps renminbi relatively low, in effect these Chinese companies wind up with less buying power than they would have had had they been able to retain the dollars. (The government institutions wind up with a lot of dollars, which they have historically used to buy U.S. Treasury bonds, although these days they are branching out somewhat.)

    In other words, if you imagine that the Chinese used dollars as their currency, the effect is essentially equivalent to the Chinese government imposing a high tax on all imports, and then just letting the tax money sit in the bank rather than using it to invest in infrastructure or social services. This makes the Chinese people poorer on average, because they neither have the income they have earned, nor do they have the benefits of the government spending that money.

    In other words, what is making the Chinese people poorer is not only that the Chinese government is controlling the currency; it is that they are controlling the currency by setting large amounts of it aside—more than a million dollars per day by some estimates.

  8. etbe said,

    October 14, 2010 @ 9:31 am

    According to the CIA the Chinese GDP was 8.748 Trillion US dollars last year or just under $29 Billion per day. $1M per day is a tiny portion of that. I’m not disagreeing with your essential point, but merely noting that $1M per day isn’t that much when considering the size of the Chinese economy.

    Now if you look at the CIA figures for the number of people below the official poverty line ($90 per annum) and the low income line ($125 per year) it seems that $1M per day distributed among the poorest Chinese people could make a huge difference.

    If $1M per day was spent on educating girls (which has been shown to be the most cost effective way of getting families out of poverty) then it would make a huge difference to rural China and in the long term it would really benefit the Chinese economy.

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