The Leading Concern: Q&A (02.16.2009)

Hillary Clinton is going to spend a lot of time in China on her first trip, and I guess that speaks to how important our relationship is with them. Do you know how China holds its peg on the dollar? And do you think they can keep it up? --Kayla (Houma, Louisiana)

Well, as far as the peg of Chinese yuan to the U.S. dollar goes—that reality does not appear to be changing anytime soon.

The way China sustains the peg is through a process known as “the impossible trinity”, a term often quoted by Nobel economics laureate Robert Mundell. This is a manipulation of money in three areas: the free capital flows in an economy, the exchange rates, and the monetary policy controlling interest rates and prices. In saying that, it’s important to note that no country can be successful at controlling monetary policy and fixing exchange rates, while, at the same time, having the luxury of free capital flows. It would seem that, inevitably, this system will break down under its own weight.

Let’s take, for example, the case of Hong Kong, which sustained a 7.80-to-1 peg against the U.S. dollar for quite sometime, since 1983. Hong Kong is a hyper-capitalist, global center with a strong penchant for free-market enterprise, and in order for that to work in this former British colony, the freedom of capital is critical. Consequently, for the city to keep its long-standing hold, the Hong Kong Monetary Authority, which is essentially a central bank, doesn’t attempt to vigorously hinder capital’s movement within the economy; it just seeks to accommodate it.

That philosophy—one that simply lets the financial markets and the local economy do their thing—can be both good and bad for a pegged Hong Kong. In fact, when foreign currencies have flooded into the local economy, and as Hong Kong’s residents and businesses have sought to convert more of those foreign currencies into HK dollars, the monetary authority has usually responded by simply printing more HK dollars, depositing the foreign currencies into their reserves, and effectively cheapening their own currency. Naturally, the extra HK dollars lead to inflationary pressure within the local economy, driving up prices on goods and services, and it does not take long before the HKMA has to step to siphon off the dollars and quell demand. It does this by either raising interest rates to entice consumers to save and not spend, or even by using its foreign reserves to buy back those dollars from banks. Hence, there is a constant need for vigilance and intervention by the monetary authority, and any misstep—perhaps, say, insufficient foreign reserves—could easily imperil the whole system, as we saw during the Asian financial crisis in 1997 and 1998.

Now China is a productive beast with different stripes, because, unlike Hong Kong, it rapaciously enforces capital controls. Taxation is heavy on consumers and businesses in the Communist country, and even as hundreds upon thousands start to partake in prosperity, many of them aren’t spendthrifts. These Chinese save more and more of their incomes, and those savings are reallocated to finance production capacity that obviously far exceeds local demand. Thus begins our love affair with China, as it churns out more and more, cheap stuff, and as the country is compelled to export that excess production around the world and notably to the United States.

Everyone should know the rest of the story. Demand for Chinese exports gives that nation a massive global, trade surplus. From January to August of 2008, alone, China’s trade surplus with the United States stood at a record $28.7 billion, even as demand was beginning to slow down. All of this money flowing back into China simply piles up in its foreign reserves, which are estimated to be in the neighborhood of $2 trillion dollars.

Immediately, even a casual observer of economics would think that, if demand for Chinese goods keeps rising, then so should the prices for those goods. And in the real world the casual observer would be right, but that’s not so in China’s world. In fact, this is where China’s peg “to a basket of currencies” seems to be so important. By fixing the yuan to currencies like the U.S. dollar and the Euro, the Chinese are able to course along the peaks and lulls as the consistently cheaper currency, and so, it is able to deliver consistently cheaper goods and services to the global marketplace. Now, in order to constantly suppress the value of its own currency and not lose its peg, China has had to become a master currency manipulator.

As foreign reserves flow into China from abroad, the country has had to print ever-greater supplies of money, in an effort to, foremost, control the exchange rate and maintain its peg. Naturally, a by-product of these piles of new yuans should be inflation, right? Well, that’s right, but that has not stopped China. The Communist government has used a lot of this money for government spending, from vast new infrastructure projects to programs meeting the needs of the millions of poor Chinese who are not participating in the boom along the eastern coast. And to a degree, it has also funneled money back into the very markets that it sells to, in order to prop up the foreign consumers and businesses buying Chinese goods and services.

What’s more, to clamp the inflation problem, the Chinese central bank and the government do a number of things. First among them is price controls. These controls on everything from real estate to the cost of fuel have left money on the table and enabled to the whole cycle to begin anew. Secondly, the central bank invokes a practice called “sterilization”, wherein it issues large amounts of government bonds, preventing the domestic money supply from growing too quickly. And lastly there are stiff capital controls essentially blocking the exits for investors, and domestic savers are also prohibited from fully converting their yuans into other foreign currencies. All of this together translates into a certain message from the Chinese government: if you have yuans, you are going to hold them—and you are going to like them.

Now, can this peg method continue? That is good question, which can immediately be answered with cautious affirmation. So long as China has plentiful foreign reserves, and so long as its production capacity overwhelms its consumption capacity, then—yeah—that peg can remain somewhat solid, much to the chagrin of many of its trading partners…

But therein lay the rub. China absolutely needs its trading partners, and the current economic crisis could test the position of the yuan peg. For instance, we have long known that the U.S. trade deficit with China, which has been fueled mostly by borrowing, was unsustainable, and now that the U.S. has been hobbled by a credit crisis, a lot of buying has simply dropped off. This means that the production capacity of the world, and particularly that of China, will drop off substantially, as well. If China is not producing, particularly in a time when the global recession can run long and deep, then Chinese workers are not working, and exports are not flowing, which also means fresh foreign capital is not entering China as the spoils of trade. Through all of this, the Communists in Beijing could find themselves wrestling with two problems. There will be the uncomfortable need to deplete their government coffers in an effort to continue to provide for roughly 65 million impoverished Chinese. And these leaders will also finally be forced to stoke their own domestic economy in a way that fundamentally, and not temporarily, increases consumption, thereby making mainland China even more market-oriented than it is today.