Tuesday, May 22, 2007

Stop Fixating on the Fixed Dollar-Yuan Peg

From today's WSJ, an excellent op-ed by Dartmouth professor Matt Slaughter ("Yuan Worries") about the misplaced concern and misgivings that the "unfairly" low value of the dollar-yuan peg is causing our massive trade "imbalance" with China ($232 billion in 2006). Professor Slaughter makes several excellent points:

1. The yuan floats against European currencies such as the euro and the pound but has been fixed against the dollar (see chart above). If nominal exchange rates were driving trade flows as commonly alleged, then Chinese exports to the U.S. should have been growing faster than to Europe. The data show something completely different, however. In 1995, monthly Chinese exports to both destinations averaged about $2 billion. By 2006, monthly Chinese exports to both destinations were still the same, at about $17 billion. Plotted together over that entire decade, these two series look nearly identical. This is because the same real economic forces -- e.g., China's relative abundance of less-skilled labor -- have been driving both sets of trade flows.

MP: And NOT the currency values, emphasis added. In other words, if China had allowed the yuan to float against the dollar in the past, the U.S. would still have a large trade deficit with China today, because real economic forces of comparative advantage drive trade flows, not nominal prices or ex-rates.

2. Many central banks today use their sovereign power to fix a nominal short-term interest rate rather than a nominal exchange rate. The U.S. Federal Reserve targets the federal-funds rate; the European Central Bank targets the main refinancing operations rate; and the Bank of Japan targets the overnight call rate. But exchange-rate targets are by no means uncommon. Indeed, in 2005, 55.6% of the world's countries fixed their exchange rates (see chart above for the Hong Kong dollar, which is pegged to the USD). And many countries have switched their targets over time. From 1945 to 1971, for example, the Federal Reserve targeted the value of the dollar at $35 per ounce of gold.

In other words, all central banks peg, fix or target something: the U.S. Fed targets interest rates (Fed Funds rate), but used to target the money supply, many central banks have an inflation target (Canada, New Zealand, Australia), and many countries have an ex-rate target (e.g. see the pegged Hong Kong dollar in the chart above). Referring to China's policy of pegging the value of the Yuan as "currency manipulation" or "unfair" would like calling the Fed's current monetary policy unfair "interest-rate manipulation." Notice also that nobody ever complains about the hundreds of countries like Hong Kong that also target or peg their ex-rate.

3. Professor Slaughter furthers explains why it might sense for China to target its ex-rate instead of its interest rates: Chinese capital markets today lack many of the microeconomic institutions that transmit changes in short-term interest rates into the broader economy: e.g., a primary-dealer market in government debt securities and, more generally, a deep network of investment and commercial banks allocating credit guided by risk-adjusted returns. This may well be one reason the PBOC maintains its exchange-rate target: An interest-rate target might weaken its linkages to the real economy.

In other words, it makes more sense for an advanced economy like the U.S. with advanced credit markets to target ("manipulate") interest rates than a developing economy like China without advanced credit markets.


At 5/22/2007 9:11 PM, Anonymous Phil said...

This comment has been removed by a blog administrator.

At 6/18/2007 8:14 AM, Blogger Grand Inquisitor Fnord Moco said...

Analysis Flaw #1: The yuan doesn't float against the Euro, the USD floats against the Euro. If there was a difference in yuan value denominated in Euros vs USDs then artbitrage brokers would be making billions. The weakened dollar artificially weakens the yuan, making the yuan even cheaper in Europe than it is in the US. Chinese exports to Europe are proportionally larger because the artificially cheap yuan is even cheaper in Europe due to the yuan/dollar peg.

China's abundance of low-skill labor is no different than Mexico's or Indonesia's or India's. Low skill labor is not what China offers. It is low cost semi-skilled and skilled labor, labor which can read and write, follow written instructions, and operate complex, efficient machinery that gives China its advantage. Simple macroeconomics tells us that if China's skilled labor is cheap and plentiful, the US and Europe's skilled labor will lower in cost or be idled while China's will rise in cost. Currently US labor is being idled. We have booming sectors of our economy that allow the millions of lost manufacturing jobs to be transitioned into new fields, but a more practical long term solution would be for currency exchange rates to level the field.

Analysis Flaw #2: "Manipulation" of interest rates does not define export prices. Interest rates only define currency flows as long as markets define two economies as essentially in balance. Too much change in interest rates will be punished by, amoung other things, devaluation of a currency. China may not have the means to control its economy via interest rates and fixing it currency exchange rate does stabilize its export driven economy, but it also prevents the natural balancing of currency markets.

The yuan currently is the albatros around the neck of western world's manufacturing sectors. China is fairly safe with its pegged currency because China can rely on the Fed's disciplined and effective management of the USD to stabilize its own economy. However, as these two competing economies diverge, China will have to devise its own fiscal management or eventually the currency peg will begin to damage China's economy as it has damaged ours.


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