This is a post from Alex Carrick's blog that covers the Canadian construction industry.

Since 1985, Mr. Carrick has held the position of Canadian Chief Economist with Reed Construction Data's CanaData, the leading supplier of statistics and forecasting information for the Canadian construction industry.

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Notes from Alex Carrick - Jan 17, 2011

Alex Carrick
How does China keep the value of its Yuan low?

A great deal of fuss has been made, particularly by U.S. government officials, over how China is gaining a foreign trade advantage by artificially keeping the value of its currency, the Yuan, low.

While this is probably true, it begs the question, “How does China manage to do it?”

First, what are the advantages to China in having a low-valued Yuan relative to the U.S. dollar? Primarily it makes the price of Chinese export goods lower than they otherwise would be. Almost 50% of the very substantial U.S. foreign trade deficit is with China at this time.

The U.S. isn’t even China’s biggest customer. That honor goes to Europe. To this point in its development spurt, China’s emergence has been based on exports of low-cost goods to the rest of the world. In that role, China has built a foreign exchange reserve fund of nearly $3 trillion.

Japan and some other nations in the Asia-Pacific region, as well as in the Middle East, also have large foreign exchange holdings, but the focus in this report is on the China-U.S. relationship.

Simply put, a nation’s foreign exchange holdings are the accumulation over many years of excess money received from all external nations versus the leakage of one’s own currency in the other direction. The monetary flows going back and forth are to purchase consumer and capital goods and services and to invest in debt instruments, with earned interest also playing a role.

A nation’s foreign exchange holdings consist of a basket of assets including cash, other nation’s notes, gold and special drawing rights issued by the International Monetary Fund (IMF). The latter are near-money and can be exchanged for “real” money through the IMF. They’re more substantial than subway tokens, food stamps or Canadian Tire money, but similar in concept.

Due to the fact China has been selling far more to the U.S. than buying from America, the relationship has evolved into one of exporter-lender (China) facilitating importer-borrower (U.S.)

Much of the U.S. dollar horde that China receives in payment for its goods is turned around by Chinese authorities and invested back in U.S. Treasury Bills, helping to hold down interest rates.

In a free-floating exchange rate system, a heavy demand for one country’s products would drive up the value of that nation’s currency. On foreign exchange markets, buyer-country A would need to exchange its currency for supplier-country B’s currency in order to make payments. Supplier-country B would want that exchange to take place so that it could meet its payrolls and purchase inputs. These foreign exchange transactions take place through brokers and agents.

There are several points of difference when confronting the Chinese adjustable fixed-rate model.

When purchasing from companies in China it needs to be remembered that they are mostly owned by the government. Beijing to date has been quite happy to simply redirect those U.S. dollar earnings back to Washington and receive Treasury notes to hold in return.

A ready supply of U.S. dollars is also handy for paying suppliers of raw materials imported into China from resource-based economies in Latin America, Africa and other countries, including Australia and Canada. Most widely-traded commodities are priced in U.S. dollars anyway.

Nor can U.S. dollars (or Euros or yen for that matter) easily flood into China to buy up assets. Efforts to do so are blocked by capital controls. One cannot simply scout around Shanghai with a wad of money in one’s back pocket and expect to be able to pick up an apartment building or mall. Such foreign investment is either not allowed or is subject to a rigorous screening process.

There are ways around such roadblocks. One is to enter into a joint partnership with a local company and funnel money through it. Another is to use the back door, which in many cases means routing money through Hong Kong. Only a certain amount of circumvention is allowed.

On the other side of the investment coin, Chinese citizens by and large are not allowed to send their money outside the country. Nobody knows to what extent this would occur if the rules were relaxed. Some observers believe it would provide the Yuan with a significant downward bias.

These are methods to limit the degree to which U.S. dollars chase Chinese Yuan, driving up the price (i.e., the exchange rate). As in most pricing issues, it’s a matter of supply versus demand.

The most powerful tool resides in the foreign exchange reserve fund. While this includes many foreign assets, there is also usually a deliberate build-up of a nation’s own domestic currency. The specific purpose is to exercise some control over the international value of one’s coinage.

When there is a high demand for supplier-nation B’s currency, B can then make such money readily available, matching demand with supply and preventing appreciation. China, with its $2.8 trillion stockpile in all manner of assets, including Yuan, can play this game all day.

(Consider the inverse. When a nation’s currency is under downward siege, local authorities often try a countering move by using foreign exchange to create an artificial demand. This fails as soon as the foreign funds are exhausted. The reason there was a run on the currency in the first place was probably because the nation in question did not have a trade surplus. In such a scenario, that nation wasn’t able to stockpile greenbacks, yen or Euros to defend its currency.)

Of course, in the extreme instance of a concerted attempt to run up the value of the Yuan, there is a last-resort option. Beijing could simply print money. This would not be favored, though, since it would exacerbate an inflation backdrop that is already of concern to the authorities.

A particularly relevant issue at this time is China’s indication that it wants to be a more responsible world citizen. One example is its willingness to pick up more of the questionable sovereign debt of financially overburdened nations in Europe. This includes notes issued by the European financial stability facility. Japan is also stepping forward in a similar manner.

This would seem to be an elegant and relatively painless way to resolve the debt crisis in Europe. There is a kicker, however. As China and Japan become more enmeshed in the affairs of Europe, this detracts from their roles as lenders to the U.S. The consequences for the U.S. may be more than minor, with a first impact perhaps showing up in a need for higher U.S. interest rates.

Alex Carrick

Find Canadian construction-related economic articles in Canadian Construction Market News and in the Economic Outlook section of Daily Commercial News. Mr. Carrick also has a lifestyle blog that can be reached by clicking here.


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