Why must the yuan appreciate against other currencies? 


31-may-2006
Why must the yuan appreciate against other currencies? Everyone has been expecting huge revaluations of the chinese renminbi against other currencies, especially the dollar, and cites the enormous trade surplus the chinese enjoy as the reason that mandates such an appreciation in the forex markets. Is there really any meat to this argument? Let us look for a moment at the mechanism at work. Conventional wisdom holds that if one country exports too much of its currency to import other goods (thus giving it a trade deficit), its currency will pile up around the world in foriegn hands and it will decrease in value as a result. Makes sense. The opposite, however, is not necessarily true. Conventional wisdom also holds that if a country exports a great deal more than it imports, that not only will it accumulate a large hoard of other nations' currency (which it will), but also that its own currency will become more highly prized beyond its borders as foriegners struggle to buy more of it in order to buy the exporter's goods. In a scenario where the creation of currency by the exporting country is restricted, either by a link to some physical commodity, or by faithful and disciplined adherence to a conservative monetary policy, this can be the case: as more foriegn exchange chases that exporting country's currency, if the money supply in that country does not increase apace with the new demand, then its forex price will rise. However, even though having a trade deficit will harm a currency's value unavoidable, having a trade surplus does not necessarily raise the exporter's currency's exchange value. The outdated notion that some amount of a country's currency represents some hard and fast share of that country's fortunes is ironically a holdover from the days before purely fiat currencies, when money supply creation was severely restricted and the flow of capital really did dictate a transfer of wealth from one denomination to another which impacted all the shares- and this itself was only an approximation, in paper, of the absolute conservation of wealth imposed by even older practices of settling balances of trade accounts in hard commodities, either by barter or through the use of, for example, precious metals- where the transfer of wealth was immediate and physical. In the modern age of purely fiat currencies, what is to stop the exporter from printing as much new currency as those eager foriegners want to buy? Fiat currency is easy to print and difficult to destroy. The path of least resistance always tends toward increasing the money supply. It is always possible to keep the value of a fiat currency low, and difficult or impossible to raise its value. If a country which enjoyed a large trade surplus were to accumulate its huge forex reserves and all the while, print ever greater amounts of its own currency to soak up the hot demand from the export business, then its currency would not appreciate significantly (or at all) against other currencies, and the country would still have the huge forex reserves that the rest of the world sent it. The fundamentals behind why a currency would rise or fall in value certainly do not dictate that a country with a strong trade surplus must in any way necessarily see an appreciation of their currency. Today, this country is China. Money supply growth in China has been in the double digits for many years. Not only is this money being printed to denominate the rapidly growing economy, but, if one looks at the numbers - 12%, 13%, 15%, annual rates in recent years - one will see that the money supply growth in China has been significantly larger than the real GDP growth, which has hovered around 8-10%. Where has the rest of this currency gone? It has gone to fuel huge speculative bubbles inside China, it has been exported to buy raw materials for China's hungry industrial machine, and it has been bought by hundreds of billions of dollars of foriegn currencies piling up in the pockets of myriad Chinese businesses and merchants. All the world wants to buy China's products, and spends good money to get them. They also seem to want China's currency, and of course, the Chinese are happy to oblige- they can print more up any time they like. From a point of view of China's advantage, it makes perfect sense to continue doing so- not only can they keep their economy booming, but they also get to inflate away debts incurred in their rapid industrialization, they get to draw even more foriegn capital or raw materials in by merely printing more paper, and, by keeping up with the global inflation race, they can remain price competetive in short term business, too. Calls, especially from US politicians, for China to revalue its currency or 'let it' appreciate to reflect its 'higher' value are pure fantasy and demagoguery. China is every bit as much a participant in the growing worldwide storm of inflation as the western countries. That they are enjoying a trade surplus at the same time and keeping real GDP growth high has just about nothing to do with the relative price of their currency and a lot to do with the fact that China's fundamentals, especially labor costs, an accomodating but strong government, lax environmental rules, and huge domestic market still being tapped into, are still positive. People saying that the renminbi should appreciate because of 'fundamentals' of supply and demand fail to understand the most important truth about the supply and demand of fiat currencies, or indeed any other object which can be reproduced at will for almost no cost. The price of the renminbi _is_ being set by supply and demand- people just aren't looking at the dynamics of, the supply of the object in question - the renminbi - and confusing it with other chinese goods, or perhaps china itself. We know the dollar is heading down, but is the renminbi heading up? Not necessarily.
This file copyright 2008