Thursday, June 30, 2011

Keeping that Currency Low

Most Americans know that the Chinese actively push down the value of their currency in order to keep their exports competitive, but how do they actually succeed in doing that? Consider, for example, an American corporation that wants to build a new auto manufacturing plant in the country. That company needs Chinese yuan in order to buy materials and hire laborers. In order to get those yuan the company will have to trade in U.S. dollars at a local branch of the Bank of China. Local branches of the Bank of China, though, have limits on how much foreign currency they can hold and branches are required to trade in their excess dollars at the Central Bank of China (the equivalent of the Federal Reserve). Now, consider the number of foreign companies setting up businesses in China. The strong demand for the currency in circulation would push up the value of the yuan. The Chinese government doesn't want that. So, when a local branch bank trades in dollars, instead of issuing currency that is already in circulation, the Central Bank just prints more yuan! Also, when the Chinese hold so many dollars (instead of selling them back into the market) or use the dollars to buy U.S. treasuries, the dollar stays strong. This is bad for U.S. exporters.

The flip side of this is that the Chinese are creating vast quantities of raw currency that could create inflation if wealth creation in China slows down.

The main drawback for China of having a weak currency is having to pay out more for oil and other natural resources that they need in massive quantities to keep their juggernaut economy rolling.

Could the U.S. do the same thing as China and push down the value of their currency? The U.S. always insists that it supports a strong currency but just look at the value of the dollar over the last decade. As the Fed continues to buy up more Treasuries and corporate debt (creating money in the process) the value of the U.S. dollar has declined. The other main reason for the dollar's decline is sluggish economic growth (foreign companies don't want to invest in the U.S.).

One of the main differeces between The Fed and China's central bank concerns independence. The Central Bank of China takes direct orders form Chinese political leaders. The Fed, while ostensibly independent, also is influenced by politics. The president appoints the Fed chairman and Congress had to approve the nomination.