Nov 02 2007

How do changing interest rates affect exchange rates? The example of the RMB

FT.com / Asia-Pacific / China – Pressure builds over renminbi

In IB Economics, we’re currently studying the determinants of exchange rates. One important factor in determining the demand for a particular currency is the interest rates in the country whose currency is in question relative to that of other countries.

The recent cut of the federal funds rate in the US of 25 basis points to 4.5% brought the US rates closer to China’s recently increasing interest rate of 3.32%. The upward trend of Chinese rates (up 50 basis points this year) and downward trend of American rates (down 50 basis points this year) should diminish the appeal of dollar denominated financial assets and increase the demand for those in Chinese RMB. In the currency market, we should see weakening demand for dollars and strengthening demand for RMB, as US savings and government securities are relatively less appealing due to the declining returns on those investments. With further increases in Chinese rates expected (due to high inflation), the RMB should be in greater demand, as returns on Chinese investments looks to increase as rates rise.

In the currency markets, this means demand for RMB should grow, leading to an appreciation of the RMB and a depreciation of the dollar. Though a truly free currency market may lead to such an outcome, the market for RMB is not truly free.

The renminbi has risen by only about 10 per cent against the US dollar since China broke its currency’s peg with the greenback in July 2005…China has been able to resist pressure for appreciation by buying the dollars coming into the country with renminbi, and then draining the local funds out of the system by selling central bank bills, a process known as sterilisation.

However, the convergence of US and Chinese interest rates threatens to turn that into a loss-making proposition for Beijing.

China has kept demand for dollars and the supply of RMB high by buying up US assets, keeping the RMB from appreciating against the dollar. Why? Weaker RMB, more US demand for Chinese goods, more growth in China… it’s all about the Benjamins…

The problem for Beijing is, while US interest rates fall, the dollar depreciates relative to world currencies as investors sell off their dollars and move their capital to countries with relatively higher rates. The weakening dollar means that China’s huge holding ($1.3 trillion) of US debt is loosing its value, giving Beijing an incentive to sell off some of its dollar assets.

Herein lies the dilemma for growth obsessed Beijing; as dollar denominated US debt is retired, dollars will be exchanged back for RMB, resulting in an increase in demand for RMB, increase in supply of dollars, and an appreciation of the RMB against the dollar. A weaker dollar and stronger RMB will shift the balance of trade, making Chinese goods more expensive for Americans, US goods cheaper for Chinese, leading to a slowdown in the export industry here in China, hence Beijing’s apprehension.

It seems that with inflation at record levels this year (upwards of 7%), a slowdown in the export industry may be just what’s needed for China. Beijing’s attempts to control food and fuel prices have only caused shortages and headaches for consumers, helping few and hurting many. 7% inflation seems to justify a loosening of monetary control by Beijing, which, given the changing relative interest rates between the US and China, will likely lead to an appreciation of the RMB (a stronger RMB), a slowdown in export growth, and a more balanced current account for both countries, as US demand for Chinese products would decrease and Chinese demand for US products would increase.

Discussion questions:

  1. Why does a lower US interest rate lead to a decrease in demand for US dollars?
  2. Why do rising Chinese interest rates lead to an increase in demand for RMB?
  3. How does China intervene in currency markets to keep the value of the RMB artificially low? What is the purpose of this intervention?
  4. What will happen to the RMB/$ exchange rate if China sells off a portion of its $1.3 of US debt?
  5. How would the balance of trade between the US and China be affected if the RMB currency market was allowed adjust without any intervention by Beijing?

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9 responses so far

9 Responses to “How do changing interest rates affect exchange rates? The example of the RMB”

  1. Angel Liuon 02 Nov 2007 at 10:37 pm

    Lower US interest rate means US dollar is worthless so people would exchange US dollars to a stronger currency. Since China’s economy is doing relatively well, investors would like to hold on to RMB; therefore, as US dollar depreciate, demand for RMB increases. From the article, it shows that Beijing is again intervening with economy’s natural tendency to adjustment to equilibrium. Beijing is loosing grip on RMB currency to allow RMB to appreciate and slow down export. I think that if China sells off a portion of its US debt, RMB/$ exchange rate might decrease because more dollars is flowing back to the US? This is my wild guess… As for the trade with the US and China, it would still be kept at equilibrium but at less Chinese export and more US import.

  2. Enno Zhangon 06 Nov 2007 at 5:04 pm

    Because when interest rates in the US are lower, then interest rates in foreign countries will seem higher which gives Americans the incentive to save their money in foreign banks, where they can get higher interest rates. When they save their money in foreign banking accounts, they have to change their dollars to another currency, decreasing the demand for dollar, depreciating it.

    Higher interest rates in China will cause more foreigners to save money in Chinese banks because it gives them higher returns. Thus, they exchange their foreign currency to RMB, thus, creating a high demand for RMB.

    China invests in America to increase the demand for the dollar and increase the supply of the RMB. This will appreciate the dollar and depreciate the RMB. Thus, for Americans, Chinese products will seem cheaper, thus, it will benefit Chinese producers.

    The RMB will appreciate because when it sells dollars for RMB, the supply of dollars will increase, causing depreciation of dollars, and the demand for RMB will increase, which appreciates RMB.

    If there were no intervention, then RMB would greatly appreciate because when foreigners buy more Chinese goods, they will increase the demand of the RMB, appreciating it.

  3. kajon 06 Nov 2007 at 8:59 pm

    Why does a lower US interest rate lead to a decrease in demand for US dollars?

    Why do rising Chinese interest rates lead to an increase in demand for RMB?

    Because more people will want to invest into chinese, and in order to do so, they need RMB.

    How does China intervene in currency markets to keep the value of the RMB artificially low?

    The Chinese government invests in America. This increases the demand for dollers and increases the supply of RMB because the chinese sell their RMB. Thus the price of the RMB will depreciate and the price of the dollar will appreciate.Therefore, to americans, chinese goods will be relatively cheaper than American goods, therefore they will import more chinese goods, thus benefitting chinese producers.

    What is the purpose of this intervention?

    To keep the prices of chinese goods low, which will cause a very high amount of exports, thus bringing a lot of money into china.

    What will happen to the RMB/$ exchange rate if China sells off a portion of its $1.3 of US debt?

    There would be an increase in the supply of RMB, thus the price of the RMB will be lower and it will be cheaper to buy RMB.

    How would the balance of trade between the US and China be affected if the RMB currency market was allowed adjust without any intervention by Beijing?

    If there was no control, many foreign countries would increase their imports from china, thus driving the price of the RMB up. Which would then slow down the imports again.

  4. Manon van Thorenburgon 09 Nov 2007 at 8:05 am

    With a decrease in the interest rate, it is less profitable for people to invest their money in American banks. People therefore must exchange their dollars to another currency and invest their money in a foreign bank, where their returns will be greater.

    With decreasing interest rates, China becomes one of the countries in which investing money is more profitable, so Americans will exchange their dollars into RMB, causing the demand for Dollars to decrease and the demand for RMB to increase.

    However, China is intervening in the currency markets to keep the value of the RMB artificially low by buying up the US assets. This leads to an increase in the supply of RMB, causing a depreciation of the RMB. This then makes Chinese goods relatively cheaper than foreign goods, leading to greater exports than imports and thus benefiting Chinese producers and allowing the Chinese economy to grow (since net exports is a component of aggregate demand).

    However, China is now holding 1.3 trillion dollars of U.S. debt. In order to sell off its debt, it will have to be exchanged back into RMB. This well therefore lead to an increase in the demand for RMB, causing it to appreciate. Chinese goods will then be relatively more expensive than american goods. Exports will decrease, imports into china will increase. According to the chinese government, this is BUHAO.

    5. How would the balance of trade between the US and China be affected if the RMB currency market was allowed adjust without any intervention by Beijing?

  5. Manon van Thorenburgon 09 Nov 2007 at 8:07 am

    With a decrease in the interest rate, it is less profitable for people to invest their money in American banks. People therefore must exchange their dollars to another currency and invest their money in a foreign bank, where their returns will be greater.

    With decreasing interest rates, China becomes one of the countries in which investing money is more profitable, so Americans will exchange their dollars into RMB, causing the demand for Dollars to decrease and the demand for RMB to increase.

    However, China is intervening in the currency markets to keep the value of the RMB artificially low by buying up the US assets. This leads to an increase in the supply of RMB, causing a depreciation of the RMB. This then makes Chinese goods relatively cheaper than foreign goods, leading to greater exports than imports and thus benefiting Chinese producers and allowing the Chinese economy to grow (since net exports is a component of aggregate demand).

    However, China is now holding 1.3 trillion dollars of U.S. debt. In order to sell off its debt, it will have to be exchanged back into RMB. This well therefore lead to an increase in the demand for RMB, causing it to appreciate. Chinese goods will then be relatively more expensive than american goods. Exports will decrease, imports into china will increase. According to the chinese government, this is BUHAO.

  6. Lucas Tophamon 12 Nov 2007 at 12:29 am

    A lower US interest rate will cause lower demand for US currency because people will change their money to other, foreign currencies where it is more profitable to save their money.

    A rising interest rate will make it more profitable for people to save their money in China because they will earn more. Therefore this desire to save money in China will cause an increased demand for RMB.

    The Chinese keep the RMB low by investing and buying American assets because this causes demand for American dollars and as people exchange their money from RMB to dollars, the supply of RMB increases causing the RMB to depreciate.

    If the Chinese government were to sell off its 1.3 trillion dollars of American debt, there would be a increased demand for RMB and therefore cause the RMB to appreciate. Also, if the American assets were sold, there would be a increase in the supply of dollars which would cause a depreciation of the American dollar.

    If the RMB appreciates, then it will appear to be relatively less cheap than before so there will be a decrease in the amount of exports to the U.S and as the RMB appreciates, it will have a greater purchasing power and therefore more people will import foreign goods.

  7. Lailaon 17 Nov 2009 at 3:01 am

    A lower US interest rate leads to a decrease in demand for the US dollar because less people will want to invest in the currency or American assets because its value wouldn’t be worth buying. The dollar will consequently depreciate. Rising Chinese interest rates will lead to a greater demand for the RMB for the same reason; because the RMB has appreciated and worth more, more investors will come in and invest in the currency, other assets and transfer their money to Chinese banks because they will get greater returns. However, China does not want their currency to appreciate by a lot because that would mean that their products would become more expensive so less countries will want to buy Chinese products, thus decreasing exports and AD. In order to keep the RMB low, the Chinese will invest in US firms, assets and currency in order to increase demand for the US dollar. This will also decrease the value of the RMB because more RMB will be supplied in the market. This kind of government intervention will benefit China because as their currency depreciates, products become cheaper therefore increasing Chinese exports and more money will flow into China.

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