On China's Currency

This is a brief summary of the effect of a fixed exchange rate between the Chinese and American currencies.

A currency fixed to another currency must have the same interest rates as the other currency. This is derived from expected interest rate parity. In a simplistic model, (the real one uses the same factors with slight modifications that don't change smaller number like the ones I'm using), if a one year bond in China returns 5% and one in America returns 7%, the assumption is that investors expect the Chinese Yuan to appreciate by 2% over the next year. Thus, when converted into American dollars, the Chinese one year bond would return its 5% plus 2% more than it would have last year, for a total of 7%, or the American rate of return. The return on the one bond, plus the additional value the currency has gained over the year, must equal the return on the other bond. Now, if the expected appreciation/depreciation is set at 0%, the Chinese interest rate, ignoring risk, must match the American interest rate. Basically, if you remove the additional value part of the equation from the, well, equation, all the remains are two equal interest rates. After all, if the Chinese interest rate stays at 5% with the American rate at 7%, no one will buy Chinese bonds because the American return is better. This will drive down the price of Chinese bonds on the market, which will increase the difference between the initial outlay and the face value. In turn, this will increase the percentage return on the bond until it reaches parity with the American bond.

In the past, the Chinese Yuan had been fixed to the American dollar. In order to maintain parity, its interest rate on similar bonds, ignoring risk, was the same. The same situation is continuing, except with China's currency fixed to a basket of currencies. The theory is the same, so for simplicity's sake we will work under the assumption that China's currency is fixed just to the American rate.

So what is China's lack of control over its interest rate doing to its economy? When any country gives up control over its interest rate, it loses the ability to speed up or slow down the economy as necessary. It is common to read that the Bank of Canada will raise interest rates to slow down the economy, or raise them to encourage growth. The problem is that China..s growth rate is vastly different than America's. In fact, the difference is about 4%, on average. This is the difference between the growth of Canada in the Depression and the average European country in the 1990's. In other words it's huge. So, while the US is keeping interest rates low to make sure its economy continues to grow, the Chinese interest rates are actually too low given the current rate of growth. The Chinese economy will grow too fast.

Basically, on a more local level, the average Chinese person will want to borrow more and save less when the country's interest rates are below where they should be. After all, if equilibrium interest is the rate where the willingness to borrow matches the willingness to lend and your country's rate is below equilibrium, the market won't clear under normal circumstances. Instead, the central bank has to finance additional lending so that the absence of lenders does not force the interest rate back up and break the fixed exchange rate. The only way the country can do this is to use contractionary fiscal policy (raising taxes or cutting spending) or expansionary monetary policy (printing more money).

Contractionary fiscal policy would see the government raise taxes or decrease spending so that the average person in China has less money. If they have less money, they cannot spend as much, which slows the economy down. In turn, this provides fewer opportunities for growth and discourages people from borrowing money. After all, if there is less demand for a product, its maker is less likely to borrow the money to expand the plant that makes it. The idea is to reduce the willingness to borrow in the market, and thus restore equilibrium. Clearly, this solution would be undesirable. The whole idea behind fixing the currency was to encourage an increase in output, which contractionary policy would completely undo.

This leaves an expansionary monetary policy. Expansionary monetary policy, rather than reducing willingness to borrow, increases the willingness to lend. The government prints new money and acts as a massive creditor for the people to maintain a market-clearing equilibrium. Thus, the money supply is greatly expanded. However, since the increase in the demand for money is not matched by an increase in the productivity of the economy, the expansion of the money supply would be purely inflationary.

This is the policy that China is currently pursuing. While it has resulted in short term growth, the long-term effects will be inflationary pressures that will discourage investment in the Chinese economy. Thus, China's policies will eventually lead to a poorer nation than had they allowed the currency to remain floating on the markets. This is the inherent cost of fixing one's currency instead of letting the market rate determine value.

So what can you do to maximize your returns on the Chinese currency? Well at some point the government will have to fight inflation. That will require them to raise the interest rates to bring prices down. Based on the parity established, the exchange rate will have to decrease, causing the Yuan to appreciate. If one were to buy a Chinese bond today, that person would get the same rate of return as the American bond and, if appreciation occurred before maturity, would receive additional payments when the bond was converted back into US currency at its higher price. In conclusion, it would be advisable for one to buy Chinese bonds now and sell them when the Yuan inevitably appreciates.