Price is what you pay. Value is what you get.
Beijing regularly complains about the “safety of it’s dollar reserves”. This political posturing makes for nice headlines and helps aggregate soft power, but your response should just be to laugh at Beijing’s naiveté and move on to the next story.
Beijing should keep some foreign currency reserves, which help to stabilize the domestic currency and encourage foreign investment. However, if Beijing did not manipulate the value of the Yuan, Beijing’s dollar reserves would not have risen to the ridiculous levels that we see now.
Today, the Chinese economy is structured to do one thing very well: make products for export. Manufacturing is a notoriously cost conscious business, and as costs in China rise, the government doesn’t want to see factories relocate en-masse to Vietnam, the Philippines, or other lower cost regions. Under normal circumstances, currencies trade a lot like stocks, prices go up and down relative to each other every day. However, every day the Chinese Yuan is worth the same amount of US Dollars. For almost 2 years, it’s been pegged at about $1.00 USD = ¥6.83 Yuan.
Trading Dollars for Yuan.
China didn’t pass a law saying that each dollar is worth 6.83 Yuan. Nobody will be tortured, jailed or executed for trading Dollars for Yuan at another rate. Instead, China’s central bank, The People’s Bank of China (PBoC), has created a policy that no matter what, they will sell you ¥6.83 Yuan for each $1.00 USD. The value of the Yuan is less than ¥6.83. Perhaps the value is ¥6.8, perhaps it’s ¥6.0, it might even be ¥5.0 or ¥4.0 for each $1 USD. However, since the PBoC is willing to sell Yuan at such a discounted price, they have a monopoly on the market. There’s no free exchange market for the Yuan, so nobody, including the PBoC can figure out exactly what the value of the Yuan should be, but the price is set by the PBoC.
Trading Yuan for Dollars
Selling Yuan is a little different story. If you have Yuan, and you want to sell them for Dollars, the PBoC doesn’t make life easy for you. Yuan sellers have to register with the PBoC and request foreign exchange. The PBoC has the choice on whether or not the Yuan sale will be permitted. For anyone investing in China, this is a very important fact to be aware of – one that I expect will bite a lot of foreign investors if the Chinese Real-Estate market bubble were to pop.
Since the PBoC is willing to give you such a great price when you sell dollars and buy Yuan, there is automatically an inward flow into Yuan, in spite of the risk that the PBoC may not let you convert Yuan back into dollars when you want to take your money back out.
If you torture the data long enough, it will confess.
The Big Pile of Dollars
As long as the PBoC keeps the peg, all of the dollar reserves that are acquired are valued by the PBoC at the price that the PBoC paid, even though the value is less than the price paid. Everybody knows that the PBoC is selling Yuan very cheap, so even more people buy Yuan (or other Chinese assets) with the intention of selling them back as soon as the price of the Yuan rises to match it’s value. Combine this with the fact that the Chinese economy is designed to produce exports, and you’ve got a recipe to up with a lot of dollars.
The PBoC has an account full of dollars corresponding to all of the Yuan, Yuan valued exports, and Yuan assets that China has sold to the rest of the world. This pile of dollars is massive and grows quickly. Since some interest on this money is better than no interest at all, the PBoC lends a lot of these dollars back to the US Federal Government, helping to finance both annual deficits and the overall debt, and pushing down interest rates.
Losses: Real or Realized
If the actual value of the Yuan in dollar terms was ¥6.70, but the PBoC’s currently pegged rate were ¥6.80, then every single time the PBoC trades a Dollar for a Yuan, it would be loosing ¥0.10 Yuan for every dollar traded. The bigger the gap between the rate that the PBoC is willing to pay for Dollars, and the the value of the Yuan, the bigger the loss on each trade. Central Banks are funded by Tax payers, so money loosing policies like this are not unheard of.
Every day for several years, the PBoC has been paying top dollar to buy dollars, even though the Dollar has been going down relative to other currencies (Euro, Yen).
(In case you didn’t notice, the flat line, least changed against the dollar, is the Chinese Yuan)
The PBoC re-values the Yuan, either by allow it’s price to be set by the market, just like the Dollar, the Euro and the Yen, or by raising the price the PBoC sells Yuan (perhaps only 6.0 Yuan for each dollar instead of 6.8 today).
THE CATCH, is that even though the PBoC is loosing money every time it buys dollars, from an accounting perspective it doesn’t look like a loss. It’s not until the price of the Yuan increases, the loss will finally look like a loss, a huge loss, to every accountant on the planet.
After the smoke clears
Someday, the PBoC will stop operating as the discount Yuan seller, thereby slowing down their accumulation of dollars, and correspondingly reducing demand for interest payments on their big pile of dollars. Less demand for dollar interest, means that the price of financing debt is going to go up. You’re not going to have many more chances to get a 30-year fixed mortgage at 5% — it was 12% in 1985.
The rising Yuan could be extremely dangerous for the Chinese economy, because there isn’t any other sector that could replace China’s manufacturing jobs. Though there are many well educated and talented Chinese entrepreneurs, the unpredictable regulatory and legal framework make investment in any R&D very high risk. Without further political reform, China appears to be stuck at the bottom of the value chain, in the Manufacturing department.