The title really says it all. And it's not a rhetorical question; I don't know the answer. But if the US is really concerned (H/T Mark Thoma) about the US dollar being too high against China's yuan, and it believes China is "artificially" preventing the yuan from appreciating against the dollar by foreign exchange market intervention, why can't the Fed just intervene in the opposite direction, by buying yuan?
Currency pegs are usually unilateral; at one time the Bank of Canada used to peg the Loonie against the US dollar. Sometimes currency pegs are bilateral; before the introduction of the Euro, France and Germany jointly intervened to keep the franc/mark exchange rate at an agreed on value. But it would be interesting to see what happened if China were trying to depreciate the yuan against the dollar, and the US were trying to depreciate the dollar against the yuan. Who would win?
Regardless of who would win, the attempt by each side to depreciate its currency against the other would increase the world money supply. Not such a bad war to have, at the moment. What's the opposite of "collateral damage"?
Update: In response to anon's comment, let me be very concrete. Suppose the Fed opens a window, somewhere on US soil, and posts a notice saying "we will buy unlimited quantities of yuan currency, bonds (or even good quality commercial paper?) at a price of X, no questions asked". Where X is above the current exchange rate set in China. What would happen? (One thing that won't happen is that China would threaten to nullify that currency or bonds, because a moment's reflection would convince China that that's a war they would definitely lose!)
Worthwhile Canadian Initiative 
The answer is that China won’t let the US buy Yuan.
The Yuan is non-convertible outside China. It is not an internationalized currency.
Another aspect of China’s rigid peg/manipulation of its exchange rate.
anon: but exactly how can China stop the US buying yuan? What does it really mean to say the yuan is “non-convertible” outside China? Sure China has a “rigid peg/manipulation” of its exchange rate. But if that peg is created by China’s buying dollars, what is to stop the Fed from establishing its own “rigid peg/manipulation” of the exchange rate, at a different exchange rate, by buying yuan?
In other words, what would happen if the Fed opened a window somewhere in the US, and posted a sign saying “we will buy unlimited quantities of yuan, at a price of X, no questions asked”?
I can’t see anything that would prevent the Fed from doing that. I’m actually rather embarrassed that I’ve never considered the question before.
Mike: it’s the sort of question I can imagine a bright first year student asking. And I’m embarrassed too that I hadn’t thought of it until this morning, and wouldn’t know how to answer a student who asked it.
It’s capital controls, more or less.
Of course, most of the dollars that flow into China are on current account, resulting in PBOC buying dollars and issuing Yuan to Chinese residents – not foreigners.
That leaves the capital account.
The Fed wouldn’t be able to buy Yuan without PBOC approval.
Basically, the US government would require Chinese approval to “purchase” any Yuan denominated Chinese financial asset (including Yuan bank deposits), which is what they’d have to do to build Yuan reserves.
E.g. the US government can’t go to a US investment dealer and buy Yuan. Can’t be done.
anon: sorry, but I just don’t understand that. The US is a sovereign country, last I heard. If the Fed wants to buy yuan on US soil, how can Chinese law prevent it?
Can the Fed prevent the Chinese from buying dollars?
In other words, PBOC is THE market for Yuan foreign exchange.
All dollar/Yuan transactions go through it.
That’s what I mean when I say the currency isn’t internationalized.
And that’s what allows China such tight control over the dollar/Yuan FX rate.
The only exception are “non-deliverable” forward markets, which as you can tell by the name, are hedging and betting oriented, but don’t have access to the actual FX – i.e. they are US dollar cash settlement for FX differentials, not Yuan settlement for contracted exchange. And they are relatively illiquid markets. If the US wants to get into the casino business to try and drive the Yuan higher, I suppose it could, but the liquidity wouldn’t be there. And there would be no actual reserves. Apart from being shady, it would backfire.
The Fed can’t prevent the Chinese from buying dollars, unless as a impeding measure it prevents US residents from paying for Chinese imports in dollars and it prevents US residents from moving dollars into Chinese approved investment in China. But it certainly can’t prevent the Chinese from buying any dollars that already exist (e.g. in bank deposit form) free floating in the world outside the US today.
“Mike: it’s the sort of question I can imagine a bright first year student asking. And I’m embarrassed too that I hadn’t thought of it until this morning, and wouldn’t know how to answer a student who asked it.”
I’m just really glad none of my students thought of asking! I teach a 4th year undergrad course on International Trade at Ivey, and this entire week was devoted to exchange rates. It could have easily come up.
Remember when someone was asking what the returns to blogging were? This is an excellent example of the returns to blogging: instant high-quality answers to questions about things we’d like to know more about but don’t.
Many thanks to anon.
“If the Fed wants to buy yuan on US soil, how can Chinese law prevent it?”
Capital controls. The Chinese government and PBOC won’t let Yuan out through the international banking system. Obviously some currency may get out, but it won’t be material.
When I say capital controls, some dollars get in, some Yuan get out. But the important word is control – tight and sufficiently tight to control the FX level at home – where (because of the corresponding foreign supply tightness) the vast bulk of FX transactions must be done by default.
In contrast, it’s pretty much impossible to prevent the flow of currency between Canada and the US, so capital controls aren’t an option for us.
The US has a free world currency in the dollar.
China has a non-free local currency in the Yuan.
It just happens to hold most of the world’s dollar reserves.
Takes two to tango to get that combination.
China will internationalize the Yuan eventually at their chosen pace (chosen pace like with everything else) – it’s the key to it’s global ascendance, and its the key to eventually resolving global imbalances, which will happen over the very long term, and will happen only because China will eventually internationalize the Yuan. They’re in the driver’s seat, even if it does cost them in terms of some dollar depreciation.
Stephen: yes, these are exactly the returns to blogging, and thanks to anon. (Hey anon, like to give yourself another nom de plume, so we can distinguish you from other anons?)
But it’s still not fully clear to me.
Let me re-pose the question a different way: If the Fed sets a dollar/yuan exchange rate of X on US soil (which it can do, by opening a window), and the Bank of China sets a dollar/yuan exchange rate of Y on Chinese soil (which it can do also, by opening a window), and X \= Y, then what is the exchange rate? Is it X or Y? Why one matters for exports and imports between China and the US? And why? (Which direction would the suitcases full of cash need to travel?)
interesting
discussion just wanted to mention that China has some currency exchange agreements with brazil and some SE Asian countries. US can use that channel.
Isn’t the problem somewhat political? In order to buy yuan, they would create more US dollars, which would also depreciate the dollar against other currencies at a time when the electorate and political establishment fret constantly about the low dollar.
If the gap between the Chinese and US exchange rates were sufficient, someone would figure out a way to thwart the capital controls. Money is a powerful motivator.
So if I understand …
The Chinese CB will buy yuan and give you US dollars at some rate they fix.
The Fed would also buy yuan and give you more US dollars per yuan the the BoCh to drive the yuan up relative to the US dollar. And since everyone with yuan would clearly prefer to get more US dollars per yuan, they’d go to the Fed and not the Chinese CB.
But the problem is, due to capital controls, nobody can get to the Fed with a suitcase (or bank account) full of yuan because it is not possible to transfer yuan out of China through ‘normal’ channels (i.e. electronic transfer), and the Chinese border guards with the automatic rifles and surgically removed senses of humour take a dim view of people leaving China with suitcases of currency.
I think my understanding is about like Patrick’s. If US exports earn yuan, it is illegal to stuff those yuan in a suitcase and bring them to the US, which you would need to do to change them for dollars at the Fed’s window. So it all depends on whether enough smugglers can be found who will smuggle yuan out of China to earn the differential? Might make a nice sideline for the drug and people smugglers, especially since the US border controls would welcome them.
Is it also illegal to stuff yuan bonds in a suitcase and bring them out of China?
Anyone old enough to remember the big “Eurodollar” market (dollar denominated bank accounts held in European banks to get around US interest rate ceilings)? What about “Ameroyuan”? Could that work?
Nick R. 10:00 a.m.:
The Fed can open a window, but what Yuan will it attract other than currency effectively smuggled out of China? Yuan currency floating around outside of China would be very limited. And the Fed won’t attract money sourced from Yuan bank deposits, because that money is subject to capital controls as a flow out of China.
The exchange rate that matters is the one determined by PBOC. That’s where Chinese exporters sell dollars and where importers source dollars. PBOC is effectively a near monopoly exchanger of Yuan for dollars.
Nick R. 11:23
US exporters don’t earn Yuan. They earn dollars. PBOC supplies dollars to Chinese importers. China won’t allow Yuan payment for its imports.
Suitcases full of Yuan bonds are illegal.
In Nick’s scenario, the effective exchange rate would be the Chinese one. If the Fed is offering a higher price for yuan (i.e. a lower dollar valuation) than the PCB, then the small amount of available paper currency would quickly be sold to the Fed and then the discrepancy would go away, as there would be nothing left for the Fed to buy. It’s like the short-side rule in disequilibrium – the exchange rate is determined by whoever can keep going the longest, which in this case is the PCB due to those capital controls.
If on the other hand there were no controls, people would simply keep arbitraging as long as the central banks are willing to keep printing money. If they can print at the same rate, the exchange rate won’t change; perhaps if one of them has better market access or more effective auction mechanisms of some kind, that one will do a bit better.
As Steve Wright said, “For my birthday I got a humidifier and a de-humidifier… I put them in the same room and let them fight it out.”
Assuming they humidify and de-humidify at the same speed, then eventually, as Nick says, both money supplies would increase until some target is reached. By this time, whatever the dollar-yuan exchange rate, both currencies would be hugely devalued against the Euro. The Europeans (and the Canadians, and the British) would be stuck with the problem – until of course they join in the inflationary spiral themselves.
I suppose if all the central banks want to keep doing this, then there’s nothing to stop them. It’s easy to unilaterally generate inflation, after all – at least we used to think so. But nobody can “win” permanently.
Devaluation is supposed to always be a short-run phenomenon – presumably money illusion only lasts so long. If your dollars and yuan can only buy 1/10 of the oil or German machinery they used to, you will sooner or later ask for a wage rise which cancels out the competitive advantage of the weaker currency. In the real world these adjustments do seem to take a while. So in the short term, whichever bank moves faster might have an advantage. But I would expect the disruptive effect on international trade to be quite powerful, and both economies might lose out more than either would gain.
There is still a Eurodollar market.
And there is still a Euroyen market.
And there is still a EuroCanadian market.
These are all generic descriptions of financial asset markets where the issuer is a non-resident of the currency’s home country.
There is no such thing as a Euroyuan market – which highlights the general point of how closed the Chinese currency is.
Agree with Leigh’s first paragraph.
But the point is that the Chinese have a fixed rate currency, and maintain capital controls on it in order to maintain their ability to fix it. They are simply not ready to float or open up their capital markets yet. Their control includes implicit control over just how much the Fed can do to fight it – which is why the US can only jawbone about China changing its policy. There is no Fed FX intervention policy possible for a currency that can’t be intervened due to the constraints imposed by the issuer of the currency.
Of course, the ability for central banks to depreciate their currencies has been the subject of some worthy recent commentary…
And for an empirical lesson from a related field: http://askville.amazon.com/Steven-Wright-recommends-putting-humidifier-dehumidifier-room/AnswerViewer.do?requestId=10867158
Perhaps there are some metaphorical lessons here for central banks…
interesting post. Dean Baker made the exact same point to me when discussing this a couple years ago: “Well guess what, we can just open a window and offer dollars at a 1-to-4 exchange rate”
Technically there is nothing to stop the US government from doing so, but ultimately I think that anon is right. With the currency controls still in place, I imagine that very little yuan would actually make it to that window.
from Krugman’s article:
“Instead, Chinese authorities enforced that target by buying or selling their currency in the foreign exchange market — a policy made possible by restrictions on the ability of private investors to move their money either into or out of the country.”
I think Krugman is a little bit off here. Private investors can move their money in and out of China, but only by exchanging it for yuan on the way in, and exchanging out of yuan on the way out, via SAFE. The main mechanism through which the Yuan is kept down is not through Forex interventions, the main mechanism is the currency control system administered by SAFE. Since they handle almost all of the exchange, they more or less ARE the market, their rate is THE rate. The rate in the (tiny and restricted) forex market for yuan closely follows the onshore rate, and I doubt that much intervention is even needed to keep it that way.
China really is in the drivers seat, and for the time being, there seems to be little hope of a revaluation. The only alternative is for the US to start slapping tariffs on currency manipulators, but that isn’t very likely.
To add to the dire outlook, Hu Jintao is on the way out in 2013, and is going to be replaced by Xi Jinping (unless the succession battle gets REALLY ugly), the protege of Jiang and leader of the Gang of Princelings (rent-seeking, corrupt children of the old revolutionaries, who now control all of the state industries and embezzle massive amounts of money through them – over 90% of China’s 100 billionaires are princelings). Unlike the Hu administration which made some attempt to revalue and rebalance the economy, I doubt that Xi will have any inclination to upset the status quo, as the peg is what ensures the centrality of the SOEs in their economy and hence his faction’s power.
“The main mechanism through which the Yuan is kept down is not through Forex interventions, the main mechanism is the currency control system administered by SAFE.”
Currency controls are a partial rationing mechanism for supply/demand – partial because they have to deal with net current account flows as well as gross capital account flows beyond that. But FX intervention is absolutely required to set the price.
“Since they handle almost all of the exchange, they more or less ARE the market, their rate is THE rate.”
Absolutely agree, as I said above.
If the Fed buys large amounts of Yuan, then it could hardly help but overpay for the yuan it buys. Thus the Fed would lose wealth, there would be less Fed assets backing each dollar, and the dollar would fall against the yuan. The policy would “succeed” in driving down the dollar, but only because the US was throwing its wealth away. An American corporation could do the same thing by using its shares of stock to overpay for stock in a Chinese company. The American company’s stock would certainly fall as a result, but there is nothing about that outcome that is desirable for America.
A scent of the control regime, from somewhere on the internet:
Click to access 11_Foreign_Exchange_Controls.pdf
Suppose the Fed opens a window, somewhere on US soil, and posts a notice saying “we will buy unlimited quantities of yuan currency, bonds (or even good quality commercial paper?) at a price of X, no questions asked”. Where X is above the current exchange rate set in China. What would happen?
What does the Fed do with the stuff? Ship it to China? The Chinese would presumably say, okay, we’ll buy it back off you for dollars. They certainly would’t credit the Fed’s account with yuan if their law says foreigners aren’t allowed to hold them.
Kevin: “What does the Fed do with the stuff?” The same as what China does with the US dollars it buys, I expect. Puts it in the vaults? But if China were to refuse to accept the validity of US-owned yuan paper, the US could easily retaliate and refuse to accept the validity of China-owned dollar paper. As I said above, that’s a war that China would definitely not want to start.
Mike: But what does “overpay” mean in this context? You are assuming that the “fundamental” value of the yuan, relative to the fundamental value of the dollar, is what China says it is. Why isn’t it what the US says it is?
anon (same “anon” for every comment here?): interesting pdf. It doesn’t explicitly say that you can’t stuff yuan in a suitcase and export it. But probably that just goes without saying.
I’m coming back to Neil’s comment. “Money” (in this case an arbitrage opportunity) is a powerful motivator. If the Fed announced a commitment to keep on buying yuan at X for several years, and thus created a steady market demand at an assured price, who knows what ways people would find to get around currency controls. Especially given corruption in China.
hmm maybe I’m just not understanding the role of the forex market in all of this.
My understanding is that it was only opened in 2005, is relatively thinly traded, and only open to certain governments and institutions. Does it really require a great deal of intervention to maintain the band?
there’s probably something I’m missing here. anon, could you perhaps explain the size and role of the forex market for RMB, or point me to a good source? As with most things China related, I find it hard to dig up much info on the web.
basically, as I understand it, the current forex market for RMB is just a foundation being laid for the future, and is not fully functioning yet
Yes. No one can hold Yuan currency outside of the country. So the Fed cannot open an exchange in NY and accept suitcases of bills. The real question is whether the Fed can open an office in China and perform the same transaction. I’m not familiar with the laws.
This is not so different from US law–suitcases of currency surely isn’t practical anyways. Foreign banks cannot hold dollars directly (yeah they can hold a bit of currency on-site and there is Fed office in NY dedicated to shipping currency overseas–mostly $100 bills, which is why the $100 bill is regarded as a proxy for foreign usage of US dollars).
No, they are required to use US banks to hold their dollars. Foreign sovereigns may not even hold the certificates of their US government debt. Those are also kept by the Fed.
The real difference is that foreigners (and foreign banks) can hold accounts at US Banks. The same is not allowed in China. THIS is the reason that there is an ‘international’ market in dollars.
BTW, your plan would not appreciate the yuan specifically, although it would depreciate the dollar against all other currencies. This is because the PBC sterilizes their support of the dollar by issuing a second currency (PBC bonds) that does not function as the medium-of-exchange but is used to subsequently withdraw the yuan used to support the dollar.
“I’m coming back to Neil’s comment. “Money” (in this case an arbitrage opportunity) is a powerful motivator. If the Fed announced a commitment to keep on buying yuan at X for several years, and thus created a steady market demand at an assured price, who knows what ways people would find to get around currency controls. Especially given corruption in China.”
My thoughts as well – I don’t think the existence of currency controls are enough to prevent the U.S. from being able to manipulate the exchange rate.
“I’m coming back to Neil’s comment. “Money” (in this case an arbitrage opportunity) is a powerful motivator. If the Fed announced a commitment to keep on buying yuan at X for several years, and thus created a steady market demand at an assured price, who knows what ways people would find to get around currency controls. Especially given corruption in China.”
The thing is, that if you are looking to arbitrage the undervaluation of the currency, and the lack of PPP between the US & Chinese markets, there is an easier way to do it. It’s perfectly legal and officially encouraged. All you have to do is order a boatload of Chinese sneakers/t-shirts/etc. and sell them on the US market. Taking undervalued currency out of the country = illegal, taking undervalued goods (non-input, finished consumer goods only) out of the country = legal. Why take the risk?
“I’m coming back to Neil’s comment. “Money” (in this case an arbitrage opportunity) is a powerful motivator. If the Fed announced a commitment to keep on buying yuan at X for several years, and thus created a steady market demand at an assured price, who knows what ways people would find to get around currency controls. Especially given corruption in China.”
The thing is, if you are looking to arbitrage the undervaluation of the currency, and the lack of PPP between the US & Chinese markets, there is an easier way to do it. It’s perfectly legal and officially encouraged. All you have to do is order a boatload of Chinese sneakers/t-shirts/etc. and sell them on the US market. Taking undervalued currency out of the country = illegal, taking undervalued goods (non-input goods only) out of the country = legal. Why take the risk?
Jon: I’m following the rest of your comment, but not this bit:
“BTW, your plan would not appreciate the yuan specifically, although it would depreciate the dollar against all other currencies. This is because the PBC sterilizes their support of the dollar by issuing a second currency (PBC bonds) that does not function as the medium-of-exchange but is used to subsequently withdraw the yuan used to support the dollar.”
So China uses sterilised intervention to reduce the quantity of US dollars in circulation without increasing the quantity of yuan in circulation. And I was imagining that the US would use unsterilised intervention to increase dollars in circulation and reduce yuan in circulation.
Why would my plan not cause the yuan to rise against other currencies (exchange controls aside)? There would be fewer yuan in circulation.
“Why can’t the Fed just buy yuan?”
How about because they don’t want to because they are trying to drive down the standard of living in the USA to the chinese level without asset prices falling for their spoiled and rich friends?
“Why can’t the Fed just buy yuan?”
What are they going to buy them with?
“Regardless of who would win, the attempt by each side to depreciate its currency against the other would increase the world money supply.”
Could you please define money supply?
“In response to anon’s comment, let me be very concrete. Suppose the Fed opens a window, somewhere on US soil, and posts a notice saying “we will buy unlimited quantities of yuan currency, bonds (or even good quality commercial paper?) at a price of X, no questions asked”. Where X is above the current exchange rate set in China. What would happen?”
What would happen? Are you serious?
China (who could print as much Yuan as they want) would simply walk up to that window with the equivilent of $400 trillion US dollars in Yuan and simply ‘buy’ 100% of America instead of only 25%.
Because they would change their behavior. They can print Yuan or sterilize more. Which gives them two degrees of freedom.
Exactly:
Could not the Fed ship containers full of USD to China, and either exchange them for yuan to horde (or lend to borrowers in China), or even just to burn? Seems to me that China would have a hard time combating this. The Fed could even just overpay for goods.
Unless I’m mistaken, there isn’t too much requiring the Fed’s reserves to be domiciled in the US, other than threat of nationalisation. And as noted, China would lose that battle.
4:59
Use a different handle, sport.
“The Fed could even just overpay for goods.”
And ask for their change back in Yuan. 🙂
Nick:
“Overpaying for yuan” means paying more than the backing of each yuan is worth. If the Chinese central bank holds various assets worth 1 oz. of silver as backing for each yuan issued, and if the Fed buys yuan for 1.01 oz each, then the Fed is overpaying. It’s the same for any financial security. If Honda stock is worth $60, and Ford buys shares for $61, Ford loses wealth and Ford stock will drop.