November 29, 2003

Something I Don't Understand

In an otherwise very good article on currency values, the Economist writes something I don't understand:

Economist.com | Currencies: Of course, one reason the dollar has fallen so sharply against the euro is that it cannot fall freely against Asia's major currencies. China’s authorities have kept the yuan controversially pegged to the dollar and Japan’s have spent well over ¥13 trillion ($120 billion) so far this year to keep the yen's value down. Asia’s central banks do not buy dollars as a rational investment; they are not looking for the best mix of risk and return. They are buying dollar assets to keep their own currencies competitive. If they think the dollar is going to fall, they may well buy more of them, rather than less...

U.S. annual GDP is about $11 trillion, Euro-zone GDP $10 trillion, Japanese GDP $6 trillion, Chinese GDP $1.3 trillion. It's easy to see how large-scale interventions by the Bank of Japan and Bank of China can move the values of the yen or the renminbi against the dollar away from what it would otherwise be. It's hard to see how their interventions would have a significant effect on the dollar-euro rate.

Think of it. Let's take as our standard of value some unaffected currency--the pound sterling, say. Demand for dollar-denominated assets falls. So we believe the dollar should fall in value relative to the pound and relative to all other currencies--unless their is large-scale intervention. And there is.

The Bank of Japan and the Bank of China buy dollars on a large scale, thus diminishing the supply of dollar-denominated assets available to meet other demands. This pushes the value of the dollar higher than it would otherwise be. The Bank of Japan and the Bank of China sell yen and renminbi-denominated assets on a huge scale to finance their dollar purchases. This pushes the value of the renminbi and the yen lower than they would otherwise be. The net effect is that the dollar-yen and dollar-renminbi exchange rates don't move: the decline in the supply of dollar-denominated assets and the rise in the supply of yen- and renminbi-denominated assets more or less offsets the fall in demand for dollars, as far as Asian currencies are concerned.

What happens to the value of the dollar against the euro as a result of Asian intervention? The supply of euro-denominated assets is unaffected. The supply of dollar-denominated assets is somewhat less. So the dollar is a little stronger against the euro than it would be in absence of intervention.

The net effect of Asian intervention--of keeping the yen and renminbi from falling relative to the dollar--is not to amplify but to damp swings in the dollar-euro rate.

I can't build a simple, plausible model in which the Economist's claim that "one reason the dollar has fallen so sharply against the euro is that it cannot fall freely against Asia's major currencies" holds true. Do I need to try harder? Or is this an argument that makes little sense?

Posted by DeLong at November 29, 2003 11:55 AM | TrackBack

Comments

You failed to comment on what I consider to be just as interesting a sentence: "Asia’s central banks do not buy dollars as a rational investment; they are not looking for the best mix of risk and return."
Yeah, well sure, if you view the world through a prism of a future three-months from now; and if you don't believe in society/the state as anything more than individuals it's not rational. If you're playing for the long term (50 yrs from now) things might look a little different. Wasn't Reagan, that republican hero, who claimed, at least after the fact, that all the time he was running a cunning plan to bankrupt the USSR? While the details of what China and Japan are doing are a little different, the grand theme is certainly not.

Posted by: Maynard Handley on November 29, 2003 01:03 PM

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"Do I need to try harder?" - OK, no, you're fine. This one was really good. But you weren't that rigorous earlier where you claimed that the USD should fall simply because of the US current deficit - as if no other macroeconomic factors were important.

One hypothesis for the Economist's mistake: Everyone thought the USD was about to go weaker, perhaps sharply so. No one wanted the USD weaker against their own currency because it would slow their business cycle recovery. So everyone said: USD should go weaker against some currencies, but not ours.

After Yen and Renmimbi is made stable, this other (major) currency is the Euro. So the Economist's idea somehow derives from the idea that the USD *has* to fall. But it hasn't.

What would happen to the economies, banking sytems, of those Asian countries buying the USD, if they stopped doing it?

Posted by: Mats on November 29, 2003 01:31 PM

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If you are a currency speculator, don't you get to choose where to attack the dollar? If you are convinced that the Asian governments will defend the dollar to the death then you sell the dollar short against the Euro. If you assume that all currency transactions are based on actual physical flows of assets and/or trade then the Economist must be wrong, but I think that in the short term, traders looking for a profit in the currency market have a lot more impact than you are giving them credit for.

Posted by: elliottg on November 29, 2003 02:03 PM

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The best argument to make here is that stimulus is not zero sum in any case. If the Euro area has excess labor they would like to utilize they should lower their rates and that can then affect somewhat the level of the Euro.

"What would happen to the economies, banking sytems, of those Asian countries buying the USD, if they stopped doing it?"

Assuming it was not done abruptly, it would help their consumers at the expense of their exporters. In a country such as China it would allow them to lower interest rates and allow more of the output to be dedicated to domestic needs (or at least they would not have to tighten to stop the current overheating). In a country like Japan it might cause trouble since they have no flexibility to lower rates. The losers would be the exporters who improperly built factories based on out of equilibrium currency rates and those who lent to them. Of course these are also the ones with the loudest voices to speak out in favor of continued manipulation. I doubt there are too many organized groups in the other direction... 'the coalition of the restrained consumer' perhaps.

Posted by: snsterling on November 29, 2003 02:09 PM

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The big deficits present, and projected, means that the value of the dollar has to fall. With the asians working to keep their currency the same relative to the US dollar, the only major currency left, is the euro, which will show the fall of the real value of the dollar.

Posted by: big al on November 29, 2003 02:15 PM

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I'm not sure elliottg is right because there's a third side to the triangle. If speculators are selling dollars for euros and the Asian CBs are buying dollars for yen and renminbi, then cannot arbitrageurs sell dollars to the Asians, buy euros with the yen and renminbi they get, then sell those euros to the speculators to get their dollars back and a little bit more?

Posted by: jam on November 29, 2003 02:29 PM

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- "Do I need to try harder?" - OK, no, you're fine. This one was really good. But you weren't that rigorous earlier where you claimed that the USD should fall simply because of the US current deficit - as if no other macroeconomic factors were important. -

Mats is quite right, and so is Brad. Nice analyses.

Posted by: anne on November 29, 2003 04:14 PM

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"U.S. annual GDP is about $11 trillion, Euro-zone GDP $10 trillion, Japanese GDP $6 trillion, Chinese GDP $1.3 trillion."

The World Bank puts Japan's GDP at almost $ trillion and China at an estimated $6 trillion. Just curious why non-adjusted GDP figures are used here....

Posted by: todd on November 29, 2003 09:47 PM

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"U.S. annual GDP is about $11 trillion, Euro-zone GDP $10 trillion, Japanese GDP $6 trillion, Chinese GDP $1.3 trillion."

The World Bank puts Japan's GDP at almost $ trillion and China at an estimated $6 trillion. Just curious why non-adjusted GDP figures are used here....

Posted by: todd on November 29, 2003 09:52 PM

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China's central bank is the People's Bank of China. Bank of China is a commercial bank, like, say, Bank of America (albeit, state owned).

And, somewhat off-topic, bad news for the U.S. debt and debt-backed securities markets: China's found something else to do with excess dollars shed from the U.S. trade imbalance:

"Economic researchers and energy experts were caught off guard by the surprisingly strong pace in oil imports despite their prediction of China's increasing need for crude oil.

With this year's oil imports set to hit 80 million tons, it seems the growth will definitely out-pace an earlier conservative forecast that imports would not reach the figure until 2010.

Zhu He, a senior engineer with China Petroleum and Chemical Corp (Sinopec), said the country's crude-oil imports were originally estimated to hit 150 to 200 million tons only in 2015.

China has been a net oil importer since 1993 with production at its key oil fields levelling off. Last year, imports rose by 15.2 per cent to reach 69.41 million tons and the dependence rate on crude oil imports is estimated to reach 30 per cent this year."

http://www1.chinadaily.com.cn/en/doc/2003-09/04/content_261146.htm

Posted by: Michael Robinson on November 30, 2003 01:47 AM

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Japan has more than just $ trillion GDP as I wrote. The World Bank must use ppp to get its under $4 trillion while Brad uses unadjusted $6 trillion. But I'm wondering why... Huge difference in the China case, though maybe not for his currency example.

Posted by: todd on November 30, 2003 06:02 AM

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--> The Bank of Japan and the Bank of China sell yen and renminbi-denominated assets on a huge scale to finance their dollar purchases. <--

Honest question: where exactly is the Bank of China dumping RMB, and who on earth is supposed to be buying?

As far as I was aware, the BoC was financing its bond purchases with its foreign exchange reserves... exchanging its non-interest bearing dollar assets for interest-bearing US bonds.

If I'm wrong, I'm dying to know who on earth bought more than 830 billion RMB last year on international currency markets (where?) and how exactly they plan to get the Bank of China to exchange it back into dollar assets before China liberalizes its currency controls in 2020 or so.

Posted by: trevelyan on November 30, 2003 10:19 AM

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Could be wrong about these things, but I think the Economist is right. Suppose there are three currencies (renminbi, dollar, euro) and China has a surplus with the U.S. of x dollars. Normally, it should be spending y of those dollars on U.S. products and (x - y) on Euro products. To spend the (x - y) on Euro products, it would be selling dollars and buying Euro, therefore pushing the dollar lower against the Euro. But it's not doing that; it's simply sending all of the x dollars back to the U.S., to put in treasuries and MBSs and what-not. Therefore y = x, and (y - x) = 0, and the Euro is not appreciating as much against the dollar as it should.

Posted by: Andrew Boucher on November 30, 2003 11:21 AM

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The Economist piece seems to assume there is some sort of weighted average penalty system at work, in which if the dollar doesn’t fall against the yuan, the yuan’s portion of the penalty must be paid elsewhere. The only sense I can make of the assertion that the dollar has to fall more against the euro when it doesn’t fall against the yuan and yen is that, if the Japan and China aren’t going to be a part of the US trade account correction, then Europe will have to handle all of it. That seems a bit much to expect, for a number of reasons.

In the grand speculative scheme of things, I think I like Jam’s answer better than Elliotg’s question. The notion that one “attacks” a currency is a bit too romantic for my taste. It is a rare case in which speculators can set out to rig an exchange rate outcome in their own favor. Sterling being booted out of the ERM may be an example, but more often, speculators bets against a currency are led by domestic capital flight. But I do agree with the notion that speculative investors try to get on the bandwagon early, to benefit from moves in fx markets (among others). That makes overshoot a more likely explanation for the swing in the Eur/Usd rate than the Economist’s view.

Trevelyan,

I’d guess the “renminbi-denominated assets” (can’t we just call it “yuan”?) are currency notes. China apparently thinks it has a bit of an inflation problem brewing - CPI is rising at nearly a 2% pace. Chinese base money (M0) has been expanding at a 15% y/y rate lately, vs something closer to 10% through most of 2002. The acceleration in M0 growth corresponds roughly to the acceleration in Chinese holdings of foreign reserves.

Posted by: K Harris on November 30, 2003 12:00 PM

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The argument works - if the Asian countries were running deficits against the EU - since this depreciates their flexible currency and since they have fixed to the dollar drags it down with the. Only problem is, is China running a deficit against the EU? Its not inconceivable, given the accuracy of its figures.

Posted by: Giles on November 30, 2003 04:29 PM

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K,

Inflation is an issue, if not as much of one as the statistics make it seem... if only due to ongoing problems in the banking sector.

My question is more that I'm not sure what RMB-denominated assets are being sold outside China. Seriously. Where does the claim that China is selling YUAN-DENOMINATED assets coming from? This doesn't make any sense to me given that the BoC is sitting on a fixed currency at a rate it can support until hell freezes over or it is $300 billion USD poorer, whatever comes first.

The only way the BoC should be able to make someone buy yuan-denominated assets is by pricing them below the market rate it is setting itself....

As far as I'm aware, even when China engages in the international bond market (as it did earlier this year for the first time since 2001), it denominates its bonds in foreign currency, not RMB.

Best,

Posted by: trevelyan on November 30, 2003 08:47 PM

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The Yuan and the Yen need to fall relative to the Euro. This is why the Dollar has to fall.

Posted by: bakho on November 30, 2003 09:34 PM

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You make sense, but I'll give you a model to get their result: Asian purchases of US treasuries designed to hold up the USD leads to 'too low' US interest rates. The result is excess consumption in the US, and a deterioration in the US trade position against ALL regions. Then USD under downward pressure, which is resisted by Asians, but not by Europeans.

Otherwise, you seem correct. I just think the little model is in fact the right one! Hence, I sell USD vs Euro on a forward outright basis (see Drobny.com for more discussion, especially review of my favorite trade at our latest conference)

regards

Posted by: Andres Drobny on November 30, 2003 09:37 PM

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You make sense, but I'll give you a model to get their result: Asian purchases of US treasuries designed to hold up the USD leads to 'too low' US interest rates. The result is excess consumption in the US, and a deterioration in the US trade position against ALL regions. Then USD under downward pressure, which is resisted by Asians, but not by Europeans.

Otherwise, you seem correct. I just think the little model is in fact the right one! Hence, I sell USD vs Euro on a forward outright basis (see Drobny.com for more discussion, especially review of my favorite trade at our latest conference)

regards

Posted by: Andres Drobny on November 30, 2003 09:42 PM

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You make sense, but I'll give you a model to get the ECONOMIST result: Asian purchases of US treasuries designed to hold up the USD leads to 'too low' US interest rates. The result is excess consumption in the US, and a deterioration in the US trade position against ALL regions. Then USD under downward pressure, which is resisted by Asians, but not by Europeans.

Otherwise, you seem correct. I just think the little model is in fact the right one! Hence, I sell USD vs Euro on a forward outright basis (see Drobny.com for more discussion, especially review of my favorite trade at our latest conference)

regards

Posted by: Andres Drobny on November 30, 2003 09:42 PM

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You make sense, but I'll give you a model to get the ECONOMIST result: Asian purchases of US treasuries designed to hold up the USD leads to 'too low' US interest rates. The result is excess consumption in the US, and a deterioration in the US trade position against ALL regions. Then USD under downward pressure, which is resisted by Asians, but not by Europeans.

Otherwise, you seem correct. I just think the little model is in fact the right one! Hence, I sell USD vs Euro on a forward outright basis (see Drobny.com for more discussion, especially review of my favorite trade at our latest conference)

regards

Posted by: Andres Drobny on November 30, 2003 09:45 PM

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You make sense, but I'll give you a model to get the ECONOMIST result: Asian purchases of US treasuries designed to hold up the USD leads to 'too low' US interest rates. The result is excess consumption in the US, and a deterioration in the US trade position against ALL regions. Then USD under downward pressure, which is resisted by Asians, but not by Europeans.

Otherwise, you seem correct. I just think the little model is in fact the right one! Hence, I sell USD vs Euro on a forward outright basis (see Drobny.com for more discussion, especially review of my favorite trade at our latest conference)

regards

Posted by: Andres Drobny on November 30, 2003 09:45 PM

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You make sense, but I'll give you a model to get the ECONOMIST result: Asian purchases of US treasuries designed to hold up the USD leads to 'too low' US interest rates. The result is excess consumption in the US, and a deterioration in the US trade position against ALL regions. Then USD under downward pressure, which is resisted by Asians, but not by Europeans.

Otherwise, you seem correct. I just think the little model is in fact the right one! Hence, I sell USD vs Euro on a forward outright basis (see Drobny.com for more discussion, especially review of my favorite trade at our latest conference)

regards

Posted by: Andres Drobny on November 30, 2003 09:47 PM

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Trevelyan: Because the yuan ain't convertible on the capital account, the People's Bank of China (not Bank of China, which is a different bank), has had to issue gobs of yuan to buy all the foreign investment and export earnings pouring into the country. This has caused the broad money supply to shoot up something like 20 percent this year, and is making them jittery about inflation. So the PBoC has stepped up issuance of short-term commercial bills in weekly open market operations to soak up the excess yuan sloshing around. I think it has issued something close to 600 billion yuan in such bills so far this year. It has also ordered the banks to raise reserve requirements to 7 percent from 6 percent to help soak up funds.

Posted by: greyford galaxie on November 30, 2003 11:00 PM

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You make sense, but I'll give you a model to get the ECONOMIST result: Asian purchases of US treasuries designed to hold up the USD leads to 'too low' US interest rates. The result is excess consumption in the US, and a deterioration in the US trade position against ALL regions. Then USD under downward pressure, which is resisted by Asians, but not by Europeans.

Otherwise, you seem correct. I just think the little model is in fact the right one! Hence, I sell USD vs Euro on a forward outright basis (see Drobny.com for more discussion, especially review of my favorite trade at our latest conference)

regards

Posted by: Andres Drobny on December 1, 2003 07:22 AM

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You make sense, but I'll give you a model to get the ECONOMIST result: Asian purchases of US treasuries designed to hold up the USD leads to 'too low' US interest rates. The result is excess consumption in the US, and a deterioration in the US trade position against ALL regions. Then USD under downward pressure, which is resisted by Asians, but not by Europeans.

Otherwise, you seem correct. I just think the little model is in fact the right one! Hence, I sell USD vs Euro on a forward outright basis (see Drobny.com for more discussion, especially review of my favorite trade at our latest conference)

regards

Posted by: Andres Drobny on December 1, 2003 07:33 AM

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You make sense, but I'll give you a model to get the ECONOMIST result: Asian purchases of US treasuries designed to hold up the USD leads to 'too low' US interest rates. The result is excess consumption in the US, and a deterioration in the US trade position against ALL regions. Then USD under downward pressure, which is resisted by Asians, but not by Europeans.

Otherwise, you seem correct. I just think the little model is in fact the right one! Hence, I sell USD vs Euro on a forward outright basis (see Drobny.com for more discussion, especially review of my favorite trade at our latest conference)

regards

Posted by: Andres Drobny on December 1, 2003 07:33 AM

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You make sense, but I'll give you a model to get the ECONOMIST result: Asian purchases of US treasuries designed to hold up the USD leads to 'too low' US interest rates. The result is excess consumption in the US, and a deterioration in the US trade position against ALL regions. Then USD under downward pressure, which is resisted by Asians, but not by Europeans.

Otherwise, you seem correct. I just think the little model is in fact the right one! Hence, I sell USD vs Euro on a forward outright basis (see Drobny.com for more discussion, especially review of my favorite trade at our latest conference)

regards

Posted by: Andres Drobny on December 1, 2003 07:34 AM

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You make sense, but I'll give you a model to get the ECONOMIST result: Asian purchases of US treasuries designed to hold up the USD leads to 'too low' US interest rates. The result is excess consumption in the US, and a deterioration in the US trade position against ALL regions. Then USD under downward pressure, which is resisted by Asians, but not by Europeans.

Otherwise, you seem correct. I just think the little model is in fact the right one! Hence, I sell USD vs Euro on a forward outright basis (see Drobny.com for more discussion, especially review of my favorite trade at our latest conference)

regards

Posted by: Andres Drobny on December 1, 2003 07:41 AM

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You make sense, but I'll give you a model to get the ECONOMIST result: Asian purchases of US treasuries designed to hold up the USD leads to 'too low' US interest rates. The result is excess consumption in the US, and a deterioration in the US trade position against ALL regions. Then USD under downward pressure, which is resisted by Asians, but not by Europeans.

Otherwise, you seem correct. I just think the little model is in fact the right one! Hence, I sell USD vs Euro on a forward outright basis (see Drobny.com for more discussion, especially review of my favorite trade at our latest conference)

regards

Posted by: Andres Drobny on December 1, 2003 08:05 AM

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You make sense, but I'll give you a model to get the ECONOMIST result: Asian purchases of US treasuries designed to hold up the USD leads to 'too low' US interest rates. The result is excess consumption in the US, and a deterioration in the US trade position against ALL regions. Then USD under downward pressure, which is resisted by Asians, but not by Europeans.

Otherwise, you seem correct. I just think the little model is in fact the right one! Hence, I sell USD vs Euro on a forward outright basis (see Drobny.com for more discussion, especially review of my favorite trade at our latest conference)

regards

Posted by: Andres Drobny on December 1, 2003 08:06 AM

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Insofar as the Chinese sell plastic toys to get USD, and use these USD to buy oil, they don't want or need to revalue their yuan, yet.

And there won't be successful pressure on China to do revaluing until the oil selling Arabs start pricing oil in Euro, but this is NOT what the US wants. So the Arabs get USD (from China), and buy ... what? European assets -- keeping the Euro high, and driving the dollar lower.

But adding this complexity doesn't solve anything, either. Back on Chinese revaluation: maybe they also want to hold low yeilding USD paper, from which they can borrow and invest in China, and try to balance internal Chinese inflation (yuan down) with external trade surplus (yuan up).

Or is this, too, merely yuan up manship?

Posted by: Tom Grey on December 2, 2003 08:06 AM

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Love can damage more than you can heal with drinking.

Posted by: Sternlicht Shoshana on December 10, 2003 09:00 PM

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