Interesting to see a lot of news article in the last few days about exchange rate wars and our Treasury Secretary asking China (without mentioning it by name but alluding to it by referring to big economies) to allow its currency to appreciate against the US dollar. http://http//news.yahoo.com/s/nm/20101006/ts_nm/us_currencies. The House has passed a bill allowing companies to seek compensation for imports from countries with misaligned exchange rates though Senate is yet to vote on it. You just can't write a letter to china asking for a compensation. So it has to be through WTO and I am not sure if WTO has made any past trade judgements based on fairness of exchange rates. This is all posturing by the Congress to show they are doing something. I am not that interested in discussing the politics of the exchange rate war but will try to talk about the fundamentals behind exchange rates. That way, we can have some sane discussion of what these exchange rate policies by different govts all over the world have on our future economic growth.
I have talked in general about exchange rates in some of my posts earlier. A monetary instrument like the dollar, remnimbi, rupee, pound etc itself is our creation. We don't have a universal world currency for trade (even though the US would like to call its dollar as a world currency) within and outside a country's border. Since we are still stuck in the notion of geographical boundaries for an entity called a country, we have different monetary instruments in the different countries. But countries have to trade with the other countries in the world in this global economy and so we get into exchange rates to figure out how much one country's monetary instrument is worth against another country's monetary instrument in the global trade. A balanced trade would have every country importing as much as it exports - they would import and export different things based on their competitive advantage in the global world. The exchange rates, if freely floated, would move up or down to get this balanced trade happen in every country. But this doesn't happen in reality due to a lot of reasons - one primary reason being that every country wants to export more than it imports. It is based on an archaic value system where individual country economies believe in saving money, even though money is just a paper we created to represent a goods or services.
Why do countries want to export more than it imports -it is a much easier economy to manage. When the exports exceed imports, everybody in the economy can save. You are not relying on just internal demand for your goods and services. If you are say an internal economy with no trade with the outside world, there needs to be borrowers and savers to keep the economy running. If some people save and if it is not borrowed, then the economic activity will weaken. Everybody can not save in an internal economy as the economic activity depends on a circle of production and consumption.
Coming back to exchange rate fundamentals, let's discuss it thru an example. Say the only countries in the world are the US and China. The currency in the US is a dollar and the currency in china is a yuan. Assume at the start the exchange rate is 1 US dollar = 7 Yuan. The US buys $1 billion worth of goods from China and China buys Y3.5 billion worth of goods from the US. At the end of the year, US has Y3.5 billion and China has $1 billion. US can not use Yuan internally and China cannot use US$ internally. If they were to swap their currency holds, then the exchange rate would come out to be 1 US dollar = 3.5 Yuan. This would be an outcome of a free floating market for both the currencies., which is very different from the initial exchange rate of 1 US$ = 7 Yuan we started off with. If the purchases of goods and services by china had been higher than the US, we could have had a devaluation of the Yuan too. A country that doesn't produce much but imports a lot of stuff from other countries will suffer exchange rate devaluations as they have very little to offer to the outside world (Zimbabwe is a prime example). But we know the currencies are not freely floated in many of the countries in the world and the central banks control the exchange rates. How does this happen?
If Chinese businesses had $1 billion in currency at the end of the year, the central bank of china will guarantee to convert this $1 billion into Y7 billion. These businesses don't have to go to an exchange market to get their currency converted. They can convert it thru their banks. What about the Y3.5 billion that chinese had bought from the US - they actually didn't buy it using their Yuan but used a portion of the $1 billion to pay the US businesses. So at the end of the year, they will be left with $500 million after paying $s for the goods they bought from the US. This $500 million can be converted at the central bank into Y3.5 billion. Due to this conversion, the chinese economy has the goods it bought from the US as well as an extra Y3.5 billion in the economy. By fixing the exchange rate, the central bank is pushing more local currency in their country and could lead to inflation but not necessarily in the CPI index. Usually leads to increase in property prices but again not a certainty either. The central bank of China then takes this $500 million and lends it to the US govt. by investing in US Treasuries. This way the money that left the US comes back as a loan - this is not a good thing for the US in the long term.
I will explore more of the effects of the exchange rate fix by countries in my next blog.
