Nov 02 2007
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 ($1.3 trillion) of US debt is loosing its value, giving Beijing an incentive to sell off some of its dollar assets.
Herein lies the dilemma for growth obsessed Beijing; as dollar denominated US debt is retired, dollars will be exchanged back for RMB, resulting in an increase in demand for RMB, increase in supply of dollars, and an appreciation of the RMB against the dollar. A weaker dollar and stronger RMB will shift the balance of trade, making Chinese goods more expensive for Americans, US goods cheaper for Chinese, leading to a slowdown in the export industry here in China, hence Beijing’s apprehension.
It seems that with inflation at record levels this year (upwards of 7%), a slowdown in the export industry may be just what’s needed for China. Beijing’s attempts to control food and fuel prices have only caused shortages and headaches for consumers, helping few and hurting many. 7% inflation seems to justify a loosening of monetary control by Beijing, which, given the changing relative interest rates between the US and China, will likely lead to an appreciation of the RMB (a stronger RMB), a slowdown in export growth, and a more balanced current account for both countries, as US demand for Chinese products would decrease and Chinese demand for US products would increase.
- Why does a lower US interest rate lead to a decrease in demand for US dollars?
- Why do rising Chinese interest rates lead to an increase in demand for RMB?
- How does China intervene in currency markets to keep the value of the RMB artificially low? What is the purpose of this intervention?
- What will happen to the RMB/$ exchange rate if China sells off a portion of its $1.3 of US debt?
- 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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