I was reading in the Economist that “the Chinese central bank continued to prop up the yuan, which is under pressure partly because of the large amount of capital that is flowing out of the country”. I don’t understand the mechanics behind that statement. If money is flowing out of the country, the money supply is going down. How is decreasing money supply consistant with currency devaluation? At the same time it does not really make sense that the currency would strengthen in event of outflow. What concept am I missing?
It just means that if you hold CNY/CNH assets and you want to sell these to buy say, USD assets, you must sell CNY and buy USD. The number of Chinese currency units in circulation doesn’t change due to this action. Someone must buy each unit from you, just at decreasing prices.
^ok, so if I am a Chinese business man who wants to buy an American hotel, I must first change my CNY to USD. This exchange is not a physical transaction, but a change in worth I have to work with. Since the CNY is effectively being sold, it drives it’s value down. Is that right?
Yes.
As China runs a current account surplus, the yuan has been in demand as you have to buy yuan before you buy Chinese goods. Over this time period people were also lining up to invest in Chinese assets, which also means buying yuan before you buy assets. These pushed the yuan up, which would have been bad for the Chinese export driven economy. To combat this, the Chinese government printed yuan to buy up large amounts of foreign assets such as US treasuries. By flooding yuan into the market and storing up foreign currency assets, they reversed some of the upward pressure on the yuan.
Recently this has reversed. With risk increasing and growth falling and concerns rising that the yuan may weaken, foreign exchange investors ran for the doors this year with about $1T in outflows. The flight of capital has hurt their markets and growth and caused the yuan to devalue as investors now have to sell the Chinese asset, then sell the yuan into foreign currency, essentially reversing the initial transactions. To combat this, China has been using their foreign reserves to now buy yuan back out of the market to support the value.
^wow… that is so cool! I grok! You just filled in a lot of holes in my understanding. Thanks, and well described.
I’m a little late to this thread, but just to add the way I’d think of it:
People write that money is flowing out of the Chinese economy, but what’s really happening is that value is flowing out of the economy, and the change in the exchange rate reflects that. The money supply is actually (in the short term) constant, and this is why it doesn’t behave the way you expected in your initial post.
When I pull my money out of China and put it back in my Citibank, NY account, I don’t change the number of CNY that are in circulation. I just exchange it with someone for some number of USD. If everyone is trying to sell their CNY at the same time and get to USD, I’m going to get a lot less USD for my CNY than if everyone is purealpha-fied and dying to dump their USD so they can get CNY. That’s why the money supply doesn’t change but the exchange rate does. Basic supply and demand here.
One way I like to think about exchange rates (qualitatively) is that a currency’s “natural value” (the value it will float at if there are no controls or central bank interventions) reflects the demand for access to things inside that economy. This means its goods and services (trade balance) and financial assets (financial balance). The balance of payments model is a more quantitative description of this basic idea, but the idea is often more useful than the mathematics, because you seldom have the numbers you need to make the math work (other than in theory).
Two other things that get talked about in terms of the desirability of an economy are “access to the labor force” and “access to the market”. Access to the labor force can basically go into the trade balance (if you are thinking in terms of contract labor and outsourcing), or financial balance (if you are thinking of locating an entire business somewhere to take advantage of the labor force - this usually gets filed under “foreign direct investment”).
“Access to their market,” when it means desiring a place to sell your goods and services (or financial assets) is something that will push a currency down, assuming that you have stuff to sell that they desire. It’s the one thing to keep in mind, because it pushes against the usual idea that “the more attractive the economy, the higher valued its currency becomes.” When the economy becomes attractive as a selling destination rather than as a producing destination, that tends to push the exchange rate down.
In practice, changes in the exchange rate reflect these changes in pressures over time, and even central bank interventions such as buying and selling reserves or manipulating interest rates to keep an exchange rate within a band are about using this mechanism to change supply and demand for the currency. If people can buy gold cheap because some central bank is selling it, or if they can get a high interest rate on government bonds (assuming the sovereign risk is tolerable), then they will try to acquire the local currency to grab it, and that pushes the exchange rate back up.
The effects of those sorts of interventions tend to be short-lived. Most currency crises involve a story of a central bank trying to defend the value of a currency and then failing. It’s hard to think of a time when these kinds of interventions saved the day (though they presumably exist). They may bring a currency out of free-fall, and there is value in neutralizing a viscious cycle like that, but they seldom prevent things from sinking lower after the quick squirt of intervention has had it’s run. It’s possible that we just don’t remember the successes because they don’t seem newsworthy, but the usual thing is that if you see a central bank doing large interventions in terms of buying and selling reserves and it makes it into the non-financial press, there’s a good chance that it’s not going to be enough.