China has probably stopped "manipulating" its currency for a while1 November, 2012, 13:20. Posted by Zarathustra
Mitt Romney claims that he would label China as currency manipulator on day in office (if he wins).
Various people have weighed in already as to whether Chinese currency is still being massively manipulated, whether China is the biggest currency manipulator of all time, and whether Chinese Yuan is actually massively undervalued at this point (see Ezra Klein’s post for more discussion).
Here, we would like to see this from another angle.
We and many others have noted that the fact that China has a large foreign reserve is largely due to China’s action to keep Chinese Yuan cheap. With large trade surplus and consistent capital account surplus in the previous decade, the only way to avoid Chinese Yuan from appreciating too quickly is to essentially print money. In the process of keeping Chinese Yuan exchange rate cheap, People’s Bank of China had to 1) print Chinese Yuan and 2) sell the newly printed Chinese Yuan to CNY buyers, of which there were many. In the process of “manipulating the currency”, the central bank ended up buying a lot of foreign assets, with much of the holding in US Treasury, etc, and the side effect of this action to intervene in the currency market is that it expands monetary base, which means a somewhat permanently excessive liquidity.
This is the story that we know too well.
However, this has changed in the past 12 months. We noted that there appears to be a dramatic change in the funds flows pattern 12 months ago: while China is still running a trade surplus, it is much smaller than pre-crisis levels. The behaviour of trading companies have changed as they seem to favour US dollar more than Chinese Yuan as their store of value (or whatever), meaning less demand for Chinese Yuan over the past 12 months. Also, the persistent and consistent capital account surplus in the previous decade has turned into capital account deficit, which is now big enough to totally offset the current account surplus which China is still currently running.
The result of capital outflow for the domestic economy is very clear. Liquidity in Chinese banking system is now longer permanently excessive. In fact, liquidity condition is now tight and very unstable, which often requires massive PBOC injection through open market operation.
There is, however, one interesting and related consequence. We have already noted before that China’s foreign reserve is no longer growing in size since one year ago.
China’s foreign reserve became this large as a result of currency market intervention as the authorities were keen to avoid Chinese Yuan from rising too quickly. The fact that China’s foreign exchange reserve has stayed more or less unchanged for around a year points to the possibility that China is really not doing much in the currency market.
In other words, China has probably stopped “manipulating” its currency for probably a year, if “manipulate” is the right verb to describe it. Whether PBOC actually intended that way or not is another matter, of course, as the market was expecting Chinese Yuan depreciation for the best part of the last 12 months, which meant that there was no point for PBOC to keep Chinese Yuan cheap, as that was where the market wanted to go anyway.
However, the recent strength of the Chinese Yuan against the US dollar points to the possibility that the Chinese central bank is still not doing much in the currency market.
If PBOC wants to keep Chinese Yuan cheap at this point, it would require them selling Chinese Yuan and buying foreign assets, which essentially injects liquidity into the domestic banking system. With liquidity injection through foreign reserve accumulation, liquidity should have been eased whenever there is inflow, as there seems to be happening currently. However, it does not seem to be happening. Instead, PBOC has to injects massive liquidity through open market operation in order to keep money market rates low.
Of course, this could be merely a political decision to do nothing ahead of the presidential election and let Chinese Yuan just rise. But the reality is the central bank has most probably stopped trying to make Chinese Yuan weaker (or stronger) for probably a year. Whether they will do it again in the coming months is yet to be seen, but for the last 12 months, they have most probably not.