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Misinterpreting Chinese Intervention in Financial Markets

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It is tempting to view economic events in China through a single template: the view that they are driven by government intervention because the authorities haven’t learned to let the market operate.  After all, Mao’s portrait still hangs on the wall and the Communist Party still governs.   But the lens of government intervention has led foreign observers to misinterpret some of the most important developments this year in the foreign exchange market and the stock market.  An instance of such misinterpretations is the confused positions of many American congressmen which have helped bring about the opposite of what they really want from China’s exchange rate.

To be sure, Chinese authorities do often intervene strongly in various ways.   In the foreign exchange market, the People’s Bank of China intervened heavily during the decade 2004-13, buying trillions of dollars in foreign exchange reserves and thus preventing the yuan from appreciating as much as it would have if it had floated freely.  Hence years of US allegations of currency manipulation. More recently, in the stock market, the authorities have deployed every piece of artillery they could think of in a crude attempt to moderate the plunge that began in June of this year.

But some important episodes that foreigners decry as the result of government intervention are in fact the opposite.  Two developments this year have dominated the financial pages, but have often been misinterpreted.  One is the depreciation of the yuan against the dollar on August 11.  The other is the bubble in the Chinese stock market that led up to the June peak.

Intervention versus the foreign exchange market

China in August gave American politicians an instance of the adage, “Be careful what you wish for, because you might get it.”  The widely decried 3% “devaluation” of the yuan was the result of a change by the People’s Bank of China in the arrangement for setting the exchange rate, a change that constituted a step in the direction of letting the market decide.  This is what US congressmen have long claimed they wanted and, even now, confusedly still claim they want.

The change sounds technical, but is easily described.  China’s central bank has for some time allowed the value of the yuan to fluctuate each day within a two per cent band, but has not routinely allowed the movements to cumulate from one day to the next.  The change on August 11 was to allow the day’s depreciation to carry over fully to the next day.  Thus market forces can play a greater role in determining the exchange rate.

It is probable that China would not have chosen this time to give the market a larger role in setting the exchange rate if market forces were not working in a direction, toward depreciation, that would help counteract this year’s weakening of economic growth.  And, peering within the country’s decision-making process, it is likely that China’s political leaders were primarily motivated by the desire to support the weakening economy while the People’s Bank of China was primarily motivated by its longer-term reform objectives.

But these two motivations are consistent: market forces would not be pushing so clearly in the direction of currency depreciation if it did not correspond to the fundamentals of the economy.    Market determination of exchange rates can indeed serve a useful function, even if the American politicians who demanded that China float did not realize what the result would be.   In any case, if what they really wanted was something different, one can hardly blame the authorities for taking them at their word.

It is said that a year is a long time in politics.  A year should have been enough time for American politicians to figure out that market forces had reversed direction in mid-2014 and that an end to Chinese intervention in the foreign exchange market would now depreciate the currency rather than appreciate it.

To be sure, China is far from a free-floating currency, let alone from full convertibility of the yuan.  Convertibility would require further liberalization of controls on financial inflows and outflows.  Unification of onshore and offshore markets, not floating of the currency, is what would be required for the yuan to merit an IMF decision this year to include the currency in the definition of its SDR (Special Drawing Right).  Much commentary ahead of the IMF decision underestimated the importance of the criterion that the currency must be “freely usable.”   Increased flexibility alone was not going to be enough to do the trick.

In truth, a 3 percent change in the exchange rate – the size of the so-called “devaluation” against the dollar – is negligible. For example the euro and Japan’s yen have each depreciated far more than this over the last year, against both the dollar and the yuan.

China’s adjustment is said to have triggered a “currency war” of devaluations, relative to the dollar, among a number of emerging market countries.  Most of this was due to happen anyway.  It has been at least a year since the economic fundamentals shifted against emerging markets (and especially away from commodities) and toward the US.   It is natural for exchange rates to adjust to the new equilibrium.  The Chinese move likely influenced the timing.  But the currency war framework is misleading.

Intervention versus the stock market

What about China’s stock market?  The commentary says not only that the authorities consistently pursued a variety of artificial measures to try to boost the market on the way down but also that they did the same during the huge run-up in stock prices between mid-2014 and mid-2015.  The allegation is that the Chinese authorities, particularly the stock market regulator, have not learned how to let the market operate and that they had only themselves to blame for the bubble in the first place.

There is some truth to this overall story.  There was some simple-minded cheer-leading of the bull market in government-sponsored news media, for example.

But many commentators have failed to notice that the regulatory authority, the China Securities Regulatory Commission, took steps to try to dampen the last six months of market run-up.   It tightened margin requirements in January 2015.  It did it again in April.  At that time it also facilitated short-selling, by expanding the number of stocks that could be sold short.  And the event which apparently in the end “pricked” the bubble was the June 12 announcement by the CSRC of plans to limit the amount brokerages could lend for stock trading.

The adjustments in margin requirements are the sort of counter-cyclical  macro prudentialregulatory policy that we economists often call for, but less often see in practice among advanced economies.  Perhaps surprisingly, it is more common in Asia and other emerging markets.  A recent study, for example, found that China and many other developing countries adjust bank reserve requirements counter-cyclically.  Another found effective use of ceilings on loan-to-income ratios to lean against excessive housing credit.

Yes, the extraordinary run-up in stock market prices from June 2014 to June 2015, when the Shanghai stock exchange composite index more than doubled, was fueled by an excessive increase in margin borrowing.  Reasons for the increase in margin borrowing include its original legalization in 2010-11; easing of monetary policy by the People’s Bank of China since November 2014 in response to slowing growth and inflation; and the eagerness of an increasing number of Chinese to take advantage of the ability to buy stocks on credit.

Nevertheless, the stock market regulator responded by leaning against the wind.  Similarly, when the People’s Bank of China has intervened in the foreign exchange market over the last year, it has been to dampen the depreciation of the yuan, not to add to it. These are not trivial points.

[A shorter version of this column appeared at Project Syndicate.  Comments can be posted there.]

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If China Stops Manipulating, Its Currency Will Depreciate

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A rare issue on which the two parties in the US Congress agree is the problem of “currency manipulation,” especially on the part of China.   Perhaps spurred by the 2014 appreciation of the dollar and the first signs of a resulting loss of American net exports, Congress is once again considering legislation to attack currencies that are seen as unfairly undervalued.  The proposed measures include the threat of countervailing duties against imports from offending countries, although that would be inconsistent with international trading rules.

Even if one accepts the possibility of identifying a currency that is manipulated, however, China no longer qualifies.  Under recent conditions, if China allowed its currency to float freely, without intervention, the renminbi would more likely depreciate against the dollar than appreciate.  US producers would then find it harder to compete on international markets, not easier.

The concepts of manipulation or unfair undervaluation are exceedingly hard to pin down from an economic viewpoint.   That China’s renminbi depreciated slightly against the dollar in 2014 [2%] is not evidence:   Many other currencies, most notably the yen and euro, depreciated by far more last year.  As a result the overall value of the renminbi was actually up slightly on an average basis during 2014 [3%], reaching an all-time high.

The sine qua non of manipulation criteria is intervention in the foreign exchange market: selling the domestic currency, in this case, the renminbi, and buying foreign currencies, the dollar, so as keep the foreign exchange value of the domestic currency lower than it would otherwise be.   To be sure, the People’s Bank of China did a lot of this over the preceding ten years.   Capital inflows on top of trade surpluses contributed to a huge balance of payments surplus.  The authorities bought the dollars needed to make up the difference, the excess supply of dollars.  The result was an all-time record level of foreign exchange reserves, reaching $3.99 trillion by July 2014.

The situation has recently changed, however.  In 2014, net capital inflows into China reversed and turned to substantial net capital outflows.  As a result, the overall balance of payments turned negative in the second half of the year, which constitutes an excess demand for dollars or excess supply of renminbi.  The People’s Bank of China actually intervened to dampen the depreciation of its currency against the dollar, the opposite of its actions over the preceding decade.  As a result, foreign exchange reserves fell to $3.84 trillion by January 2015.

There is no reason to think that this recent trend will necessarily reverse in the near future.  The downward market pressure on the renminbi relative to the dollar is easily explained by the current pattern of a relatively strong economic recovery in the US, prompting the end of a period of American monetary easing, together with a weakening of economic growth in China, prompting the start of a new period of monetary stimulus there.

Similar economic fundamentals are now at work in other countries, particularly Japan and euroland.    When the American congressmen propose to insert currency provisions into the Trans-Pacific Partnership, even though it is currently in its final stages of negotiations, they are presumably targeting Japan.  (China is not included in this trade agreement.)   They may also want to target the Eurozone in coming negotiations for the Transatlantic Trade and Investment Partnership.   Both the yen and euro have depreciated sharply against the dollar over the last year.

But, unlike China, it has been years since the Bank of Japan and the European Central Bank intervened in the foreign exchange market.   They accepted a proposal by the US Treasury to refrain from unilateral foreign exchange intervention, in an unheralded G7 ministers’ agreement two years ago.

Then what do those who charge Japan or the Eurozone with pursuing currency wars by pushing down the values of their currencies have in mind?   They have in mind the renewed monetary stimulus of recent quantitative easing programs by those central banks.   But, as the US government knows well, countries with a deficiency of demand can’t be asked to refrain from increasing the money supply or decreasing interest rates just because the likely effects include a depreciation of the currency.   One cannot even say that the likely effects include a “beggar-thy-neighbor” rise in the trade balance, because the exchange rate effect is counteracted by an income effect that boosts imports.

Indeed in 2010 it was the US that had to explain to the world that money creation is not currency manipulation.  At the time, it was the country undertaking quantitative easing and was accused by Guido Mantega, the Brazilian Finance Minister who coined the “currency wars” phrase, of being the prime aggressor.   The US hasn’t intervened in the foreign exchange market to sell dollars in a major way since the 1985 coordinated interventions associated with the Plaza Accord, which began precisely 30 years ago this month.  (There was also a smaller intervention to sell dollars in 2000, to help the euro.)

There are other criteria besides foreign exchange intervention that are used to ascertain whether a currency is undervalued or even  “manipulated” for “unfair competitive advantage,” language that is in the IMF Articles of Agreement.  One criterion is an inappropriately large surplus in its trade balance or current account balance, relative to GDP.   Another is an inappropriately low foreign exchange value for the currency, in real terms.   Many countries have large trade surpluses or low currencies.  Sometimes they are appropriate, sometimes not.  Usually it is difficult to say for sure.

China’s currency 10 years ago was unusual in that it did seem to meet all the criteria for undervaluation.  The real value of the renminbi was estimated to be about 30% below equilibrium in 2005.  The Chinese trade surplus reached 7% of GDP in 2007 and the current account surplus reached 10%.  But things have changed.   The currency appreciated about 30% in real terms between 2006 and 2013, enough that the most recent purchasing power statistics (for 2011), show it in an area that is normal for a country with real income per capita around $10,000.  The surpluses as a share of GDP came down too.  (The trade surplus is back up again over the last six months due to a fall in China’s import spending, particularly in the energy import bill.)

The criteria that US congressmen focus on is one that has no relevance for economists or for the IMF rules:  the bilateral trade balance between China and the US.   It is true that China runs a bilateral surplus with the US that is as big as ever.  At the same time, however, it runs bilateral deficits with Saudi Arabia, Australia and other exporters of oil and minerals.  And with South Korea, from whom it imports components that go into its manufactured exports.  Roughly 95% of the value of a “Chinese” smart phone exported to the US is represented by imported inputs; only 5% is Chinese value added.   The point isn’t that the trade statistics need to be corrected.  The point is, rather, that bilateral trade balances have little meaning.

If I insisted that in return for a haircut my barber must listen to me give an economics lecture, he or she would be unlikely to consider that acceptable payment.  I pay my barber in cash, and am in turn paid by Harvard University for my economics lecture.  My bilateral balances are not of concern.

Congress requires by law that the US Treasury report to it twice a year whether countries are guilty of manipulation, with the bilateral balance specified as one of the criteria.  It would be ironic if China agreed to US demands to allow the exchange rate to be determined freely in the market place and the result were a depreciation of its currency and a gain in the international competitiveness of its exporters.

[A shorter version of this column appeared at Project Syndicate.  Comments can be posted there.]

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The Latest on the Dollar’s International Currency Status

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      Most people know that the general trend in the dollar’s role as an international currency has been slowly downward since 1976.   International use of the dollar as a currency in which to hold foreign exchange reserves, to denominate financial transactions, to invoice trade, and to serve as a vehicle for foreign exchange transactions is below where it was during the heyday of the Bretton Woods era (1945-1971). 
But few are aware of what the most recent numbers show.
        It is not hard to think of explanations for the downward trend.   Since the time of the Vietnam War, US budget deficits, money creation, and current account deficits have often been high.  Presumably as a result, the dollar has lost value in terms of other major currencies or in terms of purchasing power over goods.   Meanwhile, the US share of global output has declined.  Most recently, the disturbing willingness of some American congressmen in October to pursue a strategy that would have the Treasury default on legal obligations has led some observers to ask the natural question whether the dollar’s international currency status is now imperiled.
Moreover some EM currencies are joining the list of international currencies for the first time.  Indeed, some analysts have suggested that the Chinese yuan may rival the dollar as the leading international currency by the end of the decade!  (Eichengreen, 2011; and Subramanian, 2011a, 2011b.)
         The trend in the dollar as an international currency has not been uniformly downward, however.  Interestingly, the periods when the public is most concerned about the issue do not coincide well with the periods when the dollar’s share is in fact falling.  By the criteria of international use as a reserve currency among central banks and as vehicle currency in foreign exchange markets, the most rapid declines took place during the intervals 1978-1991 and 2001-2010. (The yen and deutschemark were the rising currencies during the first period, and the euro during the second.) 
In between these two intervals, during the years 1992-2000, there was a clear reversal of the trend, notwithstanding a popular orgy of dollar declinism around the middle of that decade.  Central banks held only an estimated 46% of their foreign exchange reserves in the form of dollars in 1992, but had returned to almost 70% by 2000. 
Subsequently, the long-term downward trend resumed.  According to one estimate, the share in reserves declined from about 70% in 2001 to barely 60% in 2010 (Menzie Chinn).   During the same decade, the dollar’s share in the foreign exchange market also declined:  The currency constituted one side or the other in 90% of foreign exchange trading in 2001, but only 85% in 2010.
      The most recent statistics unexpectedly suggest that the dollar’s standing has again taken apause from its long-term decline.  The International Monetary Fund reports that its share in foreign exchange reserves stopped declining in 2010 and has been flat since then.  If anything, the share is up very slightly thus far in 2013 (COFER, IMF, Sept. 30, 2013).   Similarly, the Bank for International Settlements reported in its recent triennial surveythat the dollar’s share in the world’s foreign exchange markets rose from 85% in 2010 to 87% in 2013 (preliminary global results). That the dollar has been holding up so well comes as a surprise, in light of dysfunctional US fiscal policy.   Or maybe we should no longer be surprised.  After all, when the global financial crisis erupted out of the American sub-prime mortgage mess in 2008, the reaction of global investors was to flee into the United States, not out.  They clearly still regard the US Treasury bill market as the safe haven and the dollar as the top international currency. 
The explanation must be the one that is so often noted: the absence of good alternatives.  In particular, the euro has its own all-to-obvious problems.  Indeed the euro’s share of reserve holdings and its share of foreign exchange transactions have  both fallen by several percentage points over the last three years (reserves from 28% of allocated reserves in 2009 and 26% in 2010, to 24% in the most recent 2013 figures; forex trading from 39% of transactions in 2010 to 33% in 2013).
       What about the vaunted yuan?  According to the IMF statistics, it hasn’t yet broken into the ranks of the top seven currencies in terms of central bank reserve holdings.  The top six are the US dollar and euro, followed by the yen and pound (the latter quietly reclaimed the number three position in 2006 and has been running neck-and-neck with the yen recently), and the Canadian dollar and Australian dollar (also running neck-and-neck). According to the BIS statistics, China’s currency has finally broken into the top ten in forex trading; but its share is only 2.2% of transactions. This is behind the Mexican peso at 2.5%, and still farther behind the Canadian dollar, Australian dollar and Swiss franc.  (See Table 1 and Figures 2 & 3).  
Since 2.2% is much less than China’s share of world trade, it would be more accurate to say that the renminbi is becoming a normal currency than to say that it is becoming an international currency, let alone the top international currency.Despite recent moves by the Chinese government, the yuan  still has a long way to go.  Of the three kinds of attributes that a currency needs to become widely used internationally the yuan  has two – size of the home economy and the ability to hold its value – but still lacks the third:  deep, liquid, open financial markets.
       What might account for the recent stabilization of the dollar’s status?  What do the last three years have in common with the preceding period of temporary reversal, 1992-2000?   Both intervals saw striking improvements in the US budget deficit, both structural and overall.   The federal deficit is now less than half what it was in 2009 or 2010; and the record deficits of the 1980s were converted into record surpluses by the end of the 1990s. Perhaps the fiscal observation is a coincidence.  
It would be foolish to read too much into two historical data points.  It would be even more foolish to believe, just because American politicians have failed to dislodge the US dollar from its number one status over the last forty years, that they could not accomplish the job with another few decades of effort. 
Pound sterling had the top spot in the nineteenth century, only to be surpassed by the dollar in the first half of the twentieth century. It is not an eternal law of nature that the US currency shall always be number one.   The day may come when the dollar too succumbs in its turn.  But that day is not this day.  



Figure 1: The share of the dollar in central banks’ foreign exchange reserves stopped its downward trend in 2010-2013


source: Menzie Chinn (2013), based on IMF’s COFER.



Table 1: The share of the dollar in global foreign exchange trading reversed its downward trend in 2010-2013


Table 1


Source: Bank of International Settlements’ Triennial Central Bank Survey, Sept.2013.


Figures 2 and 3: The share of China’s yuan in foreign exchange trading is rising, but still ranks behind many other currencies

Larger image                                                                Larger image     

Source: Menzie Chinn.  Data from BIS Triennial Central Bank Survey.



Bank for International Settlements, 2013, Triennial Central Bank Survey – Foreign Exchange Turnover in April 2013: preliminary global results, Monetary and Economic Department, September.    

Menzie Chinn, 2013, “What Currencies are Foreign Exchange Reserves Held In?” Econbrowser, Oct. 31.   

Menzie Chinn and J. Frankel, 2007, ““Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” withMenzie Chinn, in G7 Current Account Imbalances: Sustainability and Adjustment,  edited by Richard Clarida (University of Chicago Press: Chicago). 

Barry Eichengreen, 2005, “Sterling’s Past, Dollar’s Future: Historical Perspectives on Reserve Currency Competition,” NBER Working Paper No.11336, May.    

 —— 2011, “The Renminbi as an International Currency.” Journal of Policy Modeling33 (5): 723-730.  

J. Frankel, 1995, “Still the Lingua Franca: The Exaggerated Death of the Dollar,” Foreign Affairs, 74, no. 4, July/August, 9-16  

 ——- 2012, “Internationalization of the RMB and Historical Precedents,” published in Journal of Economic Integration, vol.27, no.3, 329-65.  Summarized in RIETI & Vox.

International Monetary Fund, 2013, Currency Composition of Official Foreign Exchange Reserves (COFER), Sept. 30.   

Arvind Subramanian, 2011a, “Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition.” Working Paper Series No. 11-14 (Washington, D.C.: Peterson Institute for International Economics, September).   

——. 2011b. Eclipse: Living in the Shadow of China’s Economic Dominance (Washington, DC: Peterson Inst. for Int.Econ.).


[This is an extended version of a Project Syndicate op-ed.  Comments can be posted there.]












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