China's Yuan, as the Dust Settles Jude Wanniski with Paul Hoffmeister July 25, 2005

China's decision to end its decade-long policy of fixing the yuan (renminbi) at 8.28 RMB to the dollar, refixing temporarily at 8.11, was actually good for the Chinese economy while doing nothing for the U.S. economy. Because the appreciation was so slight, 2.1%, only a small number of Chinese debtors were adversely affected by the move and only a small number of U.S. creditors doing business with China were burdened by the change (unless they had hedged their positions in the forex market for a move that had been telegraphed by Treasury Secretary John Snow, who was advised several weeks ago this was in the works.)

News accounts made much of the added costs to WalMart, which buys $18 billion in goods from China, but as always happens when exchange rates change between trading partners, prices will adjust in WalMart's favor when new contracts are negotiated. This reflects the dictum of classical economics that "You cannot change the terms of trade by changing the value of the unit of account." Those taken by surprise will have windfall losses or windfall gains on existing contracts across borders. But there will be nothing permanent resolved by the China move. In the near term, it has at least quieted the know-nothings on Capitol Hill who have been screaming for a 27.5% appreciation of the yuan against the dollar -- thinking it would benefit U.S. labor at the expense of China`s. The opposite will occur in this particular case, though, because the currency link had tied China to the incipient inflation in the U.S., a point Fed Chairman Alan Greenspan has been making before Congress. It`s a small amount, but in reducing the inflation premium in yuan financial assets, it lowers the cost of capital, which is why Chinese exporters are able to adjust prices when they next negotiate with WalMart.

At the next level of sophistication, the People's Bank of China (PBOC) has announced it will allow the yuan to trade around the dollar within 0.3% on either side of 8.11, and that it will soon replace the dollar target with a basket of currencies that will no doubt be dominated by the dollar. The mixture will cushion the yuan against any major errors made by the U.S. in its management of the floating dollar. Nobody mentions the price of gold in these scenarios, but I fully expect China to adjust the yuan upward if the dollar/gold price inflates from its current $425 oz, and if the demand for dollars soars for one reason or another, taking gold to $400 oz or below, China is in a position to avoid the kind of deflationary pressures it endured during the dollar deflation of 1997-2001. We at first thought the PBOC would announce a formula for its target basket, but it seems it has adopted the strategy of its cousins at the Singapore Central Bank – targeting a mystery basket. Now it can really manipulate the yuan to optimize its value both as a unit of account for its own 1.3 billion people while also keeping its export market healthy.

The path China is on will do nothing to alter its trade surplus with the U.S. or the rest of the world, which has been the theory behind Washington`s pressure for a revaluation. It was this same theory -- which only works in a partial-equilibrium model -- that led President Nixon to break the dollar/gold link in 1971. In other words, if you do "X," then "Y" will occur, and everything will be hunky dory. In a general equilibrium model, X causes Y and Y causes Z, with ripple effects that will lead to opposite results. If you follow the money until it stops rippling, you can understand why Greenspan has been assuring Congress not to worry about China unloading its giant cache of dollar reserves. It`s mind-bending to a degree, but follow this:

If China does not buy the next Treasury bill that it would have bought to keep the yuan at 8.28, someone else will buy it with dollars, because it can`t be purchased with anything else but dollars. If China sells a T-bill out of its portfolio to adjust to the 8.11 rate, it can only sell it for dollars. What does it do with the non-interest-bearing cash it acquires? It can buy goods or services or real property available from the U.S., available only for dollars. If China prefers none of these, its remaining option is to trade them for yen or euros, using that cash to buy stuff for sale in yen or euros. But now, someone or some institution that gave up the yen or euros now has those dollars, and where do they go? They can buy stuff for sale in dollars, or they can buy those interest-bearing T-bills that were just sold by the Chinese. Hmmm.

There is more to the maze when we consider the nature of the dollars that are out there trying to find a home. Do we consider them to be "base money," dollars created out of thin air by the Fed, which are thus only liabilities of the Fed? Or have they come about through the fractional reserve banking system, which means they are not liabilities of the Fed. They simply come and go as private deals are made and consummated.

The only way they could be obligations of the Fed, base money, is if they interfere with the Fed`s domestic monetary policy of targeting the federal funds rate at 3.25%. If that is the case, the surplus liquidity would cause the ff rate to rise, perhaps to 3.26%. This would mean the Fed would have to sell bonds in the open market to mop up that surplus, to get funds back to 3.25%. Should this be the case, the Fed`s ff target will eventually, in days, nullify any effect of China not buying new T-bills or selling some of those it already has in its portfolio. On the other hand, if those dollars are not Fed obligations, they are the liabilities of private actors who are stuck with them unless they spend them on dollar assets. This problem cannot cause any disturbance to U.S. government bonds.

Remember throughout that the U.S. has an absolute monopoly on the creation or destruction of dollars. There is not a thing China or any other country can to do mess up our economy by "manipulating the dollar" or "dumping tens of billions of T-Bills" into the market. The Fed has the power to offset any inflationary or deflationary disturbance that originates outside the dollar realm. When the yuan appreciation was announced at 7 a.m. Thursday, the price of gold immediately rose by $3 oz, but at 8:35 a.m. the Fed conducted open market operations to get the funds rate back down to 3.25% and gold retreated as well. It is simply another form of "sterilization." In the same way, the dollar quickly fell against the Japanese yen, to Y110 from Y112, but it has since bounced back.

The lesson is that partial equilibrium analysis can scare policymakers into doing stupid things. Paul Krugman, the partial NYTimes columnist who also teaches at Princeton, scares his readers by arguing the economic expansion we are enjoying is being paid for with Chinese credit! And we should raise taxes, for goodness sakes!!