"Kee" Points with Jim Kee, Ph.D.

What happened in China? Last week’s big event was the “surprise devaluation” of the Chinese currency, the renminbi, which is denominated in “yuan,” the unit of account. It’s a little confusing, but the renminbi is analogous to our US “federal reserve note,” while yuan is analogous to “dollar,” or how transactions are priced. So it has become conventional to talk in terms of yuan, just as it has become conventional to talk in terms of dollars rather than Federal Reserve notes. I’ll say right up front that my knee jerk response to China’s actions was, “what took them so long?” The yuan is still loosely tied to the dollar (I’ll explain in a minute), and the dollar, the world’s main currency, has appreciated dramatically. That hurts exports, and China is still an export-oriented economy (although it is working towards changing that in the longer-term). So letting the yuan fall a bit should be a surprise to no one. A more freely floating or “market determined” yuan is also desired by the IMF as a condition for including the yuan into the international basket of currencies known as “special drawing rights,” or SDRs. That is something that both China and the IMF desire. This gets pretty far afield, but the SDR is a holdover from the Bretton-Woods system of a gold linked dollar and fixed exchange rates. Under that system, international banks held gold and SDRs as a form of collateral, and SDRs still serve that purpose among the world’s central banks. It is the unit of account for the International Monetary Fund, just as the dollar is the unit of account for the US and the yuan is the unit of account for China (makes sense, as it is a basket of currencies). China has become by most measures the world’s second largest economy, so the desired inclusion of its currency into a basket of key international currencies makes sense. China still imposes constraints on how the yuan is traded (who can or cannot buy and sell yuan), which means it is not “fully convertible” (freely tradable), and convertibility is desired by the IMF if the yuan is to be included in the SDR basket. Last week’s move by the Chinese authorities is seen as a move in that direction as well.

 

A little background: Wealth is created through production and exchange, and a stable and credible currency can facilitate wealth creation. Emerging market economies struggle with trying to achieve currency credibility, and China recognized back in 1994 that it could have instant currency credibility by fixing its currency to the dollar. That’s exactly what it did, at the rate of about 8.2 yuan per dollar (Hong Kong had fixed its currency to the dollar years before in an explicit arrangement known as a currency board). This served China well, and for a decade you could say that China got the monetary part of their policy mix right (the other part being the fiscal part). China grew dramatically, and China’s growth accelerated even further in the 2000s as China joined the World Trade Organization (end of 2001), which greatly increased the markets for its exports. As international buyers of Chinese goods increased the demand for yuan, there was pressure for the yuan to appreciate, but under the fixed exchange rate regime it was not allowed to do so. This lead to charges (notably by the US Congress!) that China was manipulating its currency to keep it from rising in order to make its exports more competitive. China actually flirted at the time with allowing the yuan to freely float, but economists (including Nobel Laureates) warned China that, while the dollar to which the yuan was pegged had credibility, a freestanding yuan – a paper currency not backed by anything and issued under a communist government – might not (it might collapse). China wisely heeded this advice, and just loosened the tie with the dollar (rather than severing it all together), effectively moving in 2005 from a fixed exchange rate to a “managed float.” Over the ensuing few years the yuan appreciated substantially and China again locked in more closely to the dollar. But since the 2007-09 crisis, China’s growth (including export growth) has slowed substantially, from as high as 13% down to an estimated 6%-6.5% today. This has put downward pressure on the yuan, just as accelerating growth put upward pressure on the yuan, and with the dollar’s strong appreciation over the past year, it makes sense that China would loosen the band within which it has kept the yuan. This is called “cutting the reference rate,” meaning the value of the yuan in reference to the dollar, the “reference currency.” They did this last week and the yuan fell amidst charges of China waging a currency war (the yuan currently trades at 6.39 per dollar). I think that’s a little too strong, as it makes sense to me that they would want to mitigate the negative effects of the strong US dollar (their reference currency) by widening the band within which the yuan is targeted. It would be odd to me if they did otherwise. And the yuan’s behavior confirmed a slowing China, which is the main message I took from the episode.

 

That’s probably enough on exchange rates! There are great debates in economics regarding the merits of fixed versus flexible exchange rates, and the press almost never covers these accurately. But I will say that the middle ground between the two, that is, “managed floats,” “pegged rates” or “crawling pegs,” etc., have very few advocates. That’s because they leave open the possibility of discretionary devaluations, which leads to speculative angst and potential capital flight, currency collapse and economic collapse. That happened in Asia following the 1997 Thai baht devaluation, leading to the “Asia meltdown.” It happened because economies there were following expansionary domestic monetary policies (printing money to buy stuff) that were at odds with a fixed or “pegged” international exchange rate. But I’ll leave that discussion for another time!