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Thursday, February 3, 2011

Currencies: How countries manipulate their value, and why (published in November of 2010 in the SB News Press)

I recently had a friend ask me to write about the value of the dollar and why and how the government manipulates its value.  Like most economic concepts, this is a complex topic.  The trick for me, as usual, is to find a way to explain something complex in an easy to understand way.  I’ll do my best!

In general, larger, industrialized countries do various things to change the value of their currencies to achieve certain economic goals.  Under most economic situations, having a relatively weak currency is preferred.  This is because these countries tend to export a lot of the products they produce and therefore, they want to keep the prices of these products relatively low in terms of other currencies (other than their own). 

A good way to think about this is to view countries like they are a business selling one product.  If Apple wants to sell more iPhones, they will lower the price.  If they lower the price, a buyer can get the same iPhone that was, let’s say, $300, for $250.  In other words, the buyer is getting the same product for $50 less.  By lowering the price, Apple would sell more iPhones, potentially increasing their profitability.

A country that lowers the value of their currency is no different than Apple—they are trying to make their products more affordable for buyers, only the buyers are from other countries.  If a buyer in the UK can get $1.40 for a euro today, and then the U.S. government lowers the value of the dollar so that the same person can get $1.50 for a euro tomorrow, that potential UK buyer can buy more ($0.10 more) stuff in dollars tomorrow than he or she could today.  If you multiply that by billions of euros and dollars, you can see why it can be very important to countries to keep their currency values low.

Here’s the rub – as with most things in economics, decisions are not made in a vacuum. As you can imagine, if both countries in our example—the U.S. and the U.K.—want to keep their currencies low, we have a serious problem.  Currencies, in general, are only weak or strong when compared to another country’s currency.  In fact, at any given time, the dollar could be weak and strong—weak against the euro and strong against the Chinese yuan, for example.  When we introduce multiple interrelationships among many currencies, one can see how the situation can get complicated very quickly.

As a direct consequence of all of these interrelationships, countries face significant challenges when trying to weaken their currency value.  China, for example, has been holding their currency, the yuan, weak against the dollar for years (since 1994 they have pegged the yuan to the dollar at an artificially low value).  They do this specifically because they want their goods to remain cheap for U.S. buyers, so we will buy more Chinese goods.  This strategy has worked well, and we can see the results clearly in their GDP growth, which is three to four times that of the U.S., and has been consistently stronger for years.  To put into monetary terms, the U.S. trade deficit with China was $30 billion in 1994 and it is about $300 billion now.

There are a variety of methods a country can use to weaken their currency, but in general they involve selling their home currency and buying the currency of the other country—the U.S. in this case, or just printing more currency (which is what we are doing now with Quantitative Easing (QE).  The Fed just announced this week that they would be taking printed dollars in the amount of $600 billion, and buying assets, such as treasuries and mortgaged-backed securities.  Their aim is to stimulate the economy, but in so doing, they will also weaken the dollar).  The buying of the dollar results in upward pressure on the value of the dollar, while the selling of the yuan in the example with China, has the effect of lowering the value of the yuan.

In practice, what happens with China is that they are exporting tons of stuff to the U.S.  They are paid in dollars for these goods, and therefore need to convert the dollars they receive back into yuan.  If they sold dollars andf bought yuan on the currency markets (like they are supposed to do), they would drive the value of the dollar down and the value of the yuan up (selling dollars and buying yuan).  Instead, they use the dollars to buy dollar-denominated assets—usually U.S. treasury bonds—thereby avoiding the impact on their currency that would otherwise take place.

There is, by the way, a law in place, called the Omnibus Trade & Competitiveness Act of 1988, which gives the president some tools to basically retaliate against a country that manipulates their currency to unfairly affect the balance of trade, etc.  However, in practice, the government never does much of anything except talk to the country—China in this case—and try to negotiate with them to stop the manipulation.  So far, although China has said they are trying to move the value of the yuan back up, they really are not doing much about it, and for good reason.  A rising value of the yuan will directly, negatively impact their economy, which is the last thing they want.

The only attempt to impose a cost on China’s distortion of global financial markets this year was congressional action on the Currency Reform for Fair Trade Act, known as the Ryan Bill, which would allow US companies to file complaints against China’s currency policies with the Commerce Department, and would empower the Department to levy tariffs and countervailing duties on imports from China.  The Ryan Bill passed in the House but stalled in the Senate.

The reality is that we need China to buy our treasuries, and to keep buying them, because we have a gargantuan national debt of about $13 trillion (and counting), and their money finances that debt to the tune of about $2 trillion.  For that reason, we don’t make too much noise about their currency manipulations.

A markedly tougher challenge for countries is trying to increase the value of their currency.  This would occur when inflation has become too high and the country is trying to lower inflation by strengthening their currency (we will very likely see this occur in the U.S. over the coming few years).  There are a few ways to strengthen a currency, but the two main ways countries use are raising interest rates and buying their currency.  Raising rates is definitely easier than buying the currency, but raising rates can have dire economic consequences.  Typically, when an economy starts to get overheated, raising rates is used as a tool to slow economic growth.  Increasing rates is an effective way to cool an economy, and is what the Fed typically does here int eh U.S. in those situations. 

The problem with raising rates is that, if they are raised too rapidly or too high, they can stifle the economy or may even cause a recession.  Worse yet, if a country is already in a tough economic situation, and they are forced to raise rates to combat a weak currency and inflation, this can really destroy their economy.  We experienced exactly this situation in the early 1980s, when Paul Volker, the then Chairman of the Fed, had to raise interest rates dramatically to combat inflation.  He was successful in decreasing inflation, but also crushed the U.S. economy in the process, and put us through one of the worst recessions, including a double-dip, that the country has ever experienced.

Personally, I have never seen any country successfully manipulate their currency over the long-term.  Most of the failures have been in countries trying to peg their currency to the U.S. dollar, holding their home currency artificially high.  China, thus far, has been pretty successful at keeping the yuan low, and has benefitted from strong economic growth as a result.  However, there are cracks starting to appear, including rampant real estate speculation and many bubbles in prices.  Further, owning $2 trillion in U.S. treasuries may not turn out to be a great investment.  One thing is certain, however, and that is that countries will continue to manipulate their currencies, and these manipulations have economic consequences that we should understand so we can plan for their potential impacts on our lives.

1 comment:

  1. There appears to be a BIG hole in this theory. The US buys Chinese products and pays for them with US dollars. Then, China buys US Treasure Bonds rather than spending the dollars to pay its workers!? Each company in China NEEDS to spend the US dollars for wages, resources, plants, etc. They can't simply sit on the money by buying US Bonds.