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From Currency Manipulation to International Acceptance

While Congress labels China a "currency manipulator," the U.S. dollar loses its luster.

Michael Rawson, 11/30/2011

Despite its pre-eminence, the U.S. dollar and its role as the world's reserve currency is threatened by unsustainable imbalances, particularly with China. Over the past year, the U.S. trade balance with China hit a record $289 billion deficit, up massively from $83 billion in 2001, the year that China entered the World Trade Organization. During this time, China accumulated $3 trillion in foreign exchange reserves. Instead of political grandstanding, the U.S. Congress should promote a better understanding of the economic constraints faced by our trading partners and a better appreciation for our responsibilities as the provider of the international reserve currency.

In a free market, the Chinese renminbi would appreciate against the dollar, thus reducing the trade deficit. By pegging its currency to the dollar and purchasing vast quantities of dollar-denominated bonds to do so, however, China perpetuates this imbalance. During his confirmation process, U.S. Treasury Secretary Timothy Geithner stated that China was engaged in currency manipulation. Recently, the U.S. Senate passed the Currency Exchange Rate Oversight Reform Act, which essentially authorizes a trade war with China and labels it a "currency manipulator." However, that pejorative term obscures the economic realities of foreign exchange and trade.

The Role of Currency
There are three functions that a useful currency performs. First, a currency serves as a unit of account, to keep track of asset values. Here, stability is key. Second, a currency must act as a medium of exchange. A currency is much more efficient than the barter system, which demands the double coincidence of wants. Third, a currency must be a good store of value. For example, if we save in dollars, we want our savings to maintain their value and not be eroded by inflation.

To qualify for reserve currency status, not only must a currency incomparably meet the above three requirements, but it also must have a deep and liquid money and bond market. This is necessary so that foreigners have plenty of currency to facilitate transactions and to hold in reserves. Here it helps to be the world’s largest economy. Of course, in this regard, nothing comes close to the dollar.

The ability of a government to issue currency at a price above the printing cost is an advantage called seignorage, which is only extended by reserve currency status. A currency can be thought of as an IOU or a short-term, non-interest-bearing loan that never gets redeemed. When a foreign nation buys dollars to hold them, it has to give up something in return. For example, it trades real goods or services for dollars, holds these dollars, and never redeems them for goods or services in return. While it is difficult to say what the value of this free lunch is for the United States, China holds nearly $2 trillion of U.S.-denominated securities (both government and private).

The Trilemma
Once two sides of a triangle are drawn, there is no uncertainty about the third. Similarly, the relationship between monetary policy, financial openness (constraints to foreign trade), and the exchange rate is a trilemma in which we can only control two of the three variables. Because international trade is such a small part of U.S. GDP and because it is the provider of the primary reserve currency, the United States shifts the burden of its exchange-rate policies to foreigners. This exorbitant privilege of the United States was laid bare by John Connally, the Treasury secretary under President Richard Nixon, who said that the dollar “is our currency but your problem.”

For the United States, the advantage of being a reserve-currency nation has simplified the trilemma (also called the Mundellian impossible trinity after Nobel prize-winning economist Robert Mundell). The Federal Reserve is free to target interest rates without concern over spillover effects on the exchange rate. Viewed in this framework, if China is a currency manipulator the Fed is certainly an interest-rate manipulator. Both forms of intervention are akin to price fixing.

While the term "manipulation" denotes a devious plot, the truth is that the supposed manipulation is implemented with a simple open-market purchase of plain-vanilla U.S. Treasuries. All the U.S. Treasury needs to do to put a halt to the game is stop selling bonds. Given the U.S. debt addiction, that is unlikely to happen.

Pegging a currency at an artificially low value is not without costs. The Chinese themselves bear the cost of this domestic financial repression as importers are forced to pay an artificially high price for foreign goods and Chinese consumers face a lower standard of living. By pegging their exchange rate, China also gives up some control over its monetary policy and has a much more difficult time controlling inflation, which again negatively has an impact on both consumers and savers. As a developing nation, these policies are reasonable if the goal is to spur export orientated economic development. But as China ascends the ranks to economic prominence, its citizens will push for the better quality of life that wealth affords.

One way to assess how nations attempt to deal with the realities of the trilemma is the Chinn Ito Index of financial openness. By this measure, China is one of the most tightly controlled financial markets among 180 counties. Despite having the world’s secondlargest economy, China is as tightly controlled as Zimbabwe and Libya. However, the index was last updated in 2009, which does not capture recent steps that China has taken to open its financial markets.

In 2003, China implemented a two-currency system to help facilitate cross-border trade yet prevent massive in- and outflows. While the renminbi is used in both Hong Kong and in mainland China, the CNY (mainland) version can trade at a different price than the CNY (Hong Kong) version. In 2005, China switched from a pegged currency to a tightly managed float, allowing the renminbi to appreciate by 2%. Although the float paused during the financial crisis, in 2010, further liberalization encouraged the renminbi’s use outside of mainland China; this enabled trade settlement and allowed foreign corporations to issue renminbi bonds (dim sum bonds) in China.

With these reforms, foreign investors have more efficient options including renminbidenominated bank accounts and bonds. Over time, it is likely that the renminbi will continue to slowly rise in value. This will help reduce trade imbalances and encourage domestic consumption. Further, it will make U.S. manufacturing more competitive, providing a boost just when it is most needed. Exports have been one of the few bright spots of the recovery, contributing 14% of GDP, up from just 10% in 2004.

At the height of the global financial crisis in March 2009, Zhou Xiaochuan, the governor of the Central Bank of China, questioned the continued use of the U.S. dollar as the reserve currency and suggested a more equitable choice, special drawing rights backed by a basket of currencies. But since that time, instead of moving toward increased use of the special drawing rights, China has instead encouraged the use of the renminbi, such as for bilateral trade settlement.

Over time, as China’s economy grows and it continues to dominate global trade, a shift may occur where the renminbi becomes an international reserve currency. But, as Arvind Subramanian of the Peterson Institute for International Economics points out, the use of renminbi as an international reserve currency would require a net outflow of renminbi to the rest of the world. Thus, China would need to run a net current account deficit. While it may seem like the transition to another currency for international trade would take decades, it can happen faster than one would expect. Barry Eichengreen suggests that it took just 10 years after the formation of the Federal Reserve in 1913 for the U.S. dollar to surpass the pound sterling.

Still, China's government lacks the basic transparency and trust that global investors demand. Rather than replace the dollar, it is more likely that the renminbi will play a larger role as the dollar’s dominance ebbs.

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