China is not Manipulating its Currency: US Treasury

When President Obama has a private lunch with Romney, his recent rival, tomorrow, one issue that is unlikely to be discussed is the Administration's decision not to charge China with manipulating the yuan.  Romney said he would cite them on his first day in office.                                               

The US used to cite China as a manipulator, but it has not done so since 1994--through Republican and Democrat Administrations.  To be sure, the Administration still realizes the Chinese yuan is significantly under-valued. Work by the IMF, however, suggests the yuan is nearing fair value.

The US Treasury noted that yuan has appreciated in real terms by about an eighth since mid-2010. In nominal terms it is up almost 9%.  It also recognizes that the PBOC has reduced its intervention in the foreign exchange market.  Some observers had argued that the PRC was allowing the yuan to strengthen ahead of the US election and that it was a cynical ploy. However, since the election the yuan has continued to strengthen and yesterday was at its strongest level in 19 years.                                             

What is interesting about the yuan's appreciation is that it seems to be less sensitive to the direction of the rest of the "secret" basket that officials are said to use to manage the currency.  Consider the euro.  Simply looking at level of the euro and the level of the yuan, the correlation over the past 60 days is inverse (-0.20).  This is down from above 0.90 as recently as early October.

Taking another stab, we ran the correlation on percentage change.  Here too, there is a inverse correlation.  Given the narrowness of the dollar-yuan bands, the correlation of the percentage change with the percentage change of a free floating euro is rarely very high.  It reached the high for the year just above 0.3 in early June.  Now its sits on the low for the year near -0.11.           

The US pressed China not simply to allow the yuan to continue to appreciate, but also to become more transparent by publishing more details about its intervention.  Note that when the PBOC intervenes, it funds its purchases of dollars by issuing yuan bills.  This is why some observers compare PBOC intervention with a variant of quantitative easing.                            

Perhaps what many observers will find the most surprising is that the US Treasury urged Chinese officials to reduce their massive reserves ($3 trillion-plus).  If China did reduce its reserves, it could mean reducing its Treasury holdings.  Apparently, US officials do not mind this as daunting as many observers who frequently fret about the implication of China selling US Treasuries.                                                                          

 In fact, China's massive holdings of US Treasuries may exacerbate the financial crisis.  It removes highly prized collateral from the system.  Consider that there is roughly $16 trillion of US sovereign debt.  The Federal Reserve itself owns about $1.5 trillion and government agencies (e.g., Social Security) own $4.8 trillion.  Foreign central banks own about $5 trillion.  This leaves a bit less than $5 trillion of this key collateral in the system.         

This also suggests some limit on what some have called QE-infinity.   It also underscores why some economists argue that QE needs to be accompanied by an expansion of Treasury supply (i.e, monetary stimulus can be more effective if it takes place along fiscal stimulus).                                             

Lastly, we note that the US Treasury also was critical of South Korea and wanted it to reduce its intervention.  Since the middle of 2010, the won has appreciated about 13% against the dollar in nominal terms.  With South Korean inflation generally running a bit above US inflation in recent years, the real appreciation of the won is somewhat more than the nominal figures suggest.