Sunday, May 28, 2006

The Mechanics of a Fixed Exchange Rate

A student emails me a question about China's exchange-market intervention:
Could you outline step-by-step how, say, $3000 spent by me on a Lenovo computer (Chinese) eventually becomes $3000 worth of debt (US Treasury bonds) owed by the United States to the Chinese government?
To keep things simple, let's suppose that China is fixing its exchange rate. (That was exactly true until recently, and is still approximately true, although China now allows some flexibility.) Here is how the situation unfolds:

1. You (an American) buy a Chinese export. To do that, you (or your retailer) has to pay the Chinese company in yuan, the Chinese currency. To get these yuan, you turn to the foreign-exchange market, supplying dollars and demanding yuan.

2. Your transaction puts upward pressure on the value of the yuan relative to the dollar.

3. The Chinese central bank, seeing the pressure on the exchange rate, intervenes in the foreign-exchange market. To keep the yuan from appreciating relative to the dollar, it supplies yuan and demands dollars.

4, The Chinese central bank has now acquired some U.S. dollars. Rather than holding these newly acquired assets in non-interest-bearing cash, it prefers interest-bearing securities. So it uses these dollars to buy U.S. Treasury bills.

In the end, your decision to buy a Chinese export has induced China to hold more U.S. government debt.

Step 3 is precisely what China critics object to. Click here and here for a discussion of the controversy.