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There are two views of current account surpluses. One is that they reflect “undervalued” currencies. Another is that they reflect saving/investment imbalances. Thus the CA surplus is the capital account deficit, which is (by definition) domestic saving minus domestic investment.

As long as the term ‘undervalued’ is purely descriptive, with no normative implications, then both views are correct. David Glasner has a very good post on the Chinese CA surplus and China’s exchange rate policy. I mostly agree, but will take up his challenge in the following quotation. I think I can offer a perspective that clarifies some of the issues David raises.

That leaves another, less focused, method by which governments can offer protection from international competition to certain industries or groups. The method is precisely for the government and the monetary authority to do what Keynes’s Law says can’t be done: to choose an exchange rate that undervalues the currency, thereby giving an extra advantage or profit cushion to all producers of tradable products (i.e., export industries and import-competing industries), perhaps spreading the benefits of protection more widely than governments, if their choices were not restricted by international agreements, would wish. However, to prevent the resulting inflow of foreign cash from driving up domestic prices and eliminating any competitive advantage, the monetary authority must sterilize the induced cash inflows by selling assets to mop up the domestic currency just issued in exchange for the foreign cash directed toward domestic exporters. . . . But to borrow a concept from Austrian Business Cycle Theory, this may not be a sustainable long-run policy for a central bank, because maintaining the undervalued exchange rate would require the central bank to keep accumulating foreign-exchange reserves indefinitely, while selling off domestic assets to prevent the domestic money supply from increasing. The central bank might even run out of domestic assets with which to mop up the currency created to absorb the inflow of foreign cash. But in a rapidly expanding economy (like China’s), the demand for currency may be growing so rapidly that the domestic currency created in exchange for the inflow of foreign currency can be absorbed by the public without creating any significant upward pressure on prices necessitating a sell-off of domestic assets to prevent an outbreak of domestic inflation. It is thus the growth in, and the changing composition of, the balance sheet of China’s central bank rather than the value of the dollar/yuan exchange rate that tells us whether the Chinese are engaging in currency manipulation. To get some perspective on how the balance sheet of Chinese central banks has been changing, consider that Chinese nominal GDP in 2009 was about 2.5 times as large as it was in 2003 while Chinese holdings of foreign exchange reserves in 2009 were more than 5 times greater than those holdings were in 2003. This means that the rate of growth (about 25% a year) in foreign-exchange reserves held by the Chinese central bank between 2003 and 2009 was more than twice as great as the rate of growth in Chinese nominal GDP over the same period. Over that period, the share of the total assets of the Chinese central bank represented by foreign exchange has grown from 48% in December 2003 to almost 80% in December 2010. Those changes are certainly consistent with the practice of currency manipulation. However, except for 2009, there was no year since 2000 in which the holdings of domestic assets by the Chinese central bank actually fell, suggesting that there has been very little actual sterilization undertaken by the Chinese central bank. If there has indeed been no (or almost no) actual sterilization by the Chinese central bank, then, despite my long-standing suspicions about what the Chinese have been doing, I cannot conclude that the Chinese have been engaging in currency manipulation. But perhaps one needs to look more closely at the details of how the balance sheet of the Chinese central bank has been changing over time. I would welcome the thoughts of others on how to interpret evidence of how the balance sheet of the Chinese central bank has been changing.

I’d like to point out that while the central bank often does the job of boosting domestic saving (and hence depreciating the real exchange rate) by purchasing lots of foreign assets, there is no logical reason to connect this “saving” policy with monetary policy. The Chinese government could have another agency (the Treasury?) tell exporters to sell their dollar earnings to them. This agency would raise yuan funds via taxes (not printing money) and then use these yuan funds to buy dollars from Chinese exporters. The agency would then presumably swap the dollars for interest earning dollar assets like T-bonds. This would put downward pressure on the Chinese real exchange rate for the exact same reason that sterilized Chinese central bank purchases of dollars would put downward pressure on the exchange rate.

Actual Chinese exchange rate manipulation usually involves three factors:

1. More Chinese government saving.

2. The saving is done by the central bank.

3. The central bank keeps the nominal exchange rate pegged.

But only the first is important. If the Chinese government saves a huge percentage of GDP, and total Chinese saving rises above total Chinese investment, then by definition China has a CA surplus. And this surplus would occur even if the exchange rate were floating, and if the purchases were done by the Chinese Treasury, not its central bank. That’s why you often see huge CA surpluses in countries that don’t have pegged exchange rates (Switzerland (prior to the recent peg), Singapore, Norway, etc). They have government policies which involve either enormous government saving (Singapore and Norway) or policies that encourage private saving (Switzerland.) It should also be noted that government saving does not automatically produce a CA surplus. Australia is a notable counterexample. The Aussie government does some saving, but the private sector engages in massive borrowing from the rest of the world, so they still end up with a large CA deficit.

Why does the Chinese currency manipulation seem “worse” than other countries? Obviously China is big, so it gets noticed. And obviously China often does peg its nominal exchange rate. That draws the attention of the 99.99% of policymakers who have never read Mankiw’s intro textbook, and don’t realize that government saving (not pegged exchange rates) causes CA surpluses. If the PBoC pegged the rate but didn’t accumulate foreign assets, then they’d be forced to inflate, and the real exchange rate would rise. Or (as David points out) if they bought foreign assets but didn’t sterilize the purchases then they’d produce inflation, which would push the real exchange rate higher.

In addition to the currency peg, China also has its central bank do lots of saving by accumulating massive holdings of foreign assets. That confuses even those people who do know that the real issue is the government saving, not the fixed exchange rate. They forget that it makes no difference whether the extra government saving is done via central banks, or via things like sovereign wealth funds, tax breaks on saving, etc. So China gets noticed.

In the end none of this should matter, as the job situation in the US is determined by two factors:

1. US supply-side policies

2. US NGDP growth (i.e. monetary policy.)

China plays no role in either, unless we are stupid enough to let it play a role in #2. If so, we have no one but ourselves to blame.

I don’t know enough about the PBoC balance sheet to comment on David’s specific claim. My hunch is that you’d want to look at the entire balance sheet of the Chinese government. If the total saving of the Chinese government seems “high” relative to some arbitrary standard, you could call that currency manipulation. I have absolutely no idea, however, how much the Chinese government should be saving. So while the Chinese government is almost certainly trying to manipulate the real exchange rate, I have no idea whether the real exchange rate would be all that different if there was no intentional “manipulation,” just Chinese saving done for the usual reasons. China’s real exchange rate is not particularly unusual for a low income country.

Most countries save too little, as government policies are usually biased toward current consumption, and double-tax patient people who prefer future consumption.

Memo to liberals: If the world saved as much as it should, there would almost certainly be a massive boom in “infrastructure” investment. A sound monetary policy would also help.

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This entry was posted on November 04th, 2012 and is filed under China. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



