Tag Archives: Exchange rate

[REVISED] Who Touched My RMB?

It’s always interesting to see how economic predictions and financial manipulations fail in China. The ridiculously high population/resource ratio turns China into a hungry giant that can easily overturn any rules: the Wall Street tycoons lost to Chinese housewives during the “gold battle”; Chinese government tried to stop the housing market’s craziness but ended up being one of the biggest obstacle to the success of taming the market. The list goes on and on.

And now it’s the RMB issue again. Bear with me if this topic is becoming increasingly boring for you. As the RMB’s behavior is totally going against the theory, it’s tempting to looking into the reasons behind all the weirdness.

Ever since the year of 2005, RMB has been appreciating internationally while depreciating domestically.

rmb_exchange_rate

Picture source: XE

rmb_inflation_rate

Picture source: Trading Economics

As explained clearly in this about.com thread, the value of a currency should be synchronized domestically and internationally. On one hand, when the exchange rate of RMB goes up, in theory, the demand of RMB will increase, leading to a decrease in the amount of liquidity, therefore the inflation will be alleviated, and eventually the value of RMB will go up. On the other hand, a higher value of RMB attracts investment from oversea, which will lead to a higher demand of RMB in the foreign exchange market and therefore drive up its exchange rate. However, historical data suggested differently: internationally up, domestically down. Why?

It’s a known fact that RMB was long undervalued in the foreign exchange market because of the government’s intervention. As Beijing gradually loose the leash, the exchange rate is bound to increase. So it must be the inflation, which comes from within the country, that’s causing the mismatch problem.

About the inflation, the government claims that “there exists measurement error that skews the statistical data”, and “the CPI data doesn’t fully reflect the reality”. Of course these official speech is too ambiguous to be believed, let alone the “CPI misreporting” can be interpreted both ways. As I see it, this inflation is due to the governments’ over-manipulation to the economy.

This manipulation is not the usual fiscal and monetary policy we’ve seen everyday. The level of governmental intervention in China is much higher than that. Since it’s difficult to explain this in theory, I’ll demonstrate it with China’s “land finance” example.

By constitution, all lands of China are owned by the central government. Therefore, Chinese government has control over the real estate pricing. To stimulate the local economy, local governments make huge spending every day, which almost always yields to budget deficits. To compensate the deficit, the most effective way is to sell the lands that are owned by the government. This is when things get crazy: since the government has control over the lands’ price, it can sell a certain piece of land at an extremely high price. And thanks to the heated housing market, there’s always a buyer. As a result, the price of houses almost doubles every year. House owners’ pockets are therefore inflated. The liquidity drastically increase in the market, and hence the inflation.

This kind of government intervention to the economy is not something foreseeable from the textbook, and the “land finance” is merely one piece of the puzzle. In a not-so-liberal economy, the government’s overexertion of its power to gain short-run benefit is clearly bringing problems to the economy. The mismatch of RMB value is one such example. What’s next? How to prevent these problems from happening in the future? Beijing needs to give better answers to these questions.

South Korea’s export boost and its exchange rate

In my previous blog post South Korean Exchange Rate, I analyzed how South Korean exchange rate fluctuated over last few years and affected my “college life”. I decided to come to US when Korean Won-US dollar exchange rate was around 900Won per dollar in 2008, but decided to go back to Korea to fulfill military service for two years when exchange rate rose to over 1532.8 Won per dollar in early 2009. My parents had to send 77million Won instead of 45million Won per year to pay my tuition, and I thought it was a good time to fulfill military service in Korea and wait for won-dollar exchange rate to settle down.

Nonetheless, it was a good decision. The exchange rate settled down to around 1100 won per dollar by the time I got discharged from Korean army and returned to University of Michigan. As shown in the graph from FRED below, won-dollar exchange rate fall to 1035.4 won per dollar this April. It is the lowest since August 2008, yet IMF believes South Korea won is still undervalued. According to the Wall Street Journal Article IMF Says South Korea Won Undervalued, South Korea’s won currency could be up to 8% undervalued and urged authorities to refrain from intervening in currency markets.

exchange rate

In particular, US treasury this week called on South Korea to limit its interventions in foreign exchange markets, as it believes that South Korea currency is unfairly cheap, making US exports more costly by comparison. However, the main reason for United States’ trade deficit with Korea is due to its free trade agreement. According to the news article from New Hampshire Business Review The U.S. should think twice about yet another free trade deal, United States’ trade deficit with Korea has increased $8.7 billion or 59.6%, costing nearly 600,000 U.S jobs after the FTA was established. Furthermore, the graph below which shows value of total exported goods exported by Korea tells us that Korea’s export has no strong correlation; when Korean won was weakest (year 2009), the quantity of export is lower then what the quantity of export in year 2014, when Korean won is relatively stronger.

export value

 

Although it is true that weaker currency can help a country to boost its trade surplus, I do not think that Korea’s recent trade boost is due to its “weak” currency. From the two graphs we can see that Korea’s currency has been appreciating since year 2009, yet its export quantity has been increasing as well. I may be biased (as I am Korean), but I think it is bit harsh for IMF to tell Korea to stop intervening in its currency saying Korea’s export boost is due to its weak currency. Korean companies have been producing fine products, from electronics to cars, and I think this is the main reason for the boost in export; not weak currency.

(Revised) South Korea worries over interest rate.

In April 11, South Korea’s currency Korean Won (KRW) hit its record low exchange rate at 1,035 KRW per dollar, largest appreciation to reach the highest level since 2008. Although Korea’s economy is slowly gaining international recognition, but there are still obstacles for Korea to reach stability and still rag for higher growth.

According to South Korea Finance Minister Hyun Oh Seok, interest rate rise might pose great threat at home. South Korea have generally fared well despite 2008 financial crisis and Euro zone debt crisis. Just to see few data on inflation control and interest rate see charts:

Screen Shot 2014-04-12 at 12.22.54 PM Screen Shot 2014-04-12 at 12.43.25 PM

We see that there was a huge drop in nominal interest rate from above 5% down to 2%, and at the same time inflation dropped at about the same rate. As a result, the real interest had little influence. This abled Korea to control capital in/outflow and eventually the export quantity. Because it lacks natural resource endowments in its territory, Korea is quite dependent on its exports in order to buy necessary goods from foreign country. One characteristic of Korean exports is that it is focused on technological value added items . To name a few, cell phones, TV’s, naval engineering goods and automobiles are some of more known items.

As a result, in order for South Korea to be really stay on its competitive edge requires favorable financial conditions, especially those regarding exchange rates and interest rates. So, what happened to Korea in the past few months? There has been a huge appreciation in KRW and some economists in Korea worry that this will be a head wind against its growth in coming years.

Screen Shot 2014-04-12 at 12.52.23 PM

Another big concern for Korea right now is climbing household debt level reaching its record high (see graph below) at a wrong time. The Fed is continuing to taper quantitative easing programs, and the talk of whether interest rate will increase sooner than anticipated will also play a role in markets other than that of US. Why Korea should really be worried is that most of household debt is tied to mortgage in floating interest rate. Not to mentioned the housing prices rising due to cultural flux of real estate as a popular investment options, the trend of borrowing to finance these houses drive the prices up. Consequently, if interest rate hike around the world raises interest rates in Korea, burden on household could cause a series of default, which would in turn drive down the housing prices as well.

Screen Shot 2014-04-12 at 12.39.39 PM

High debt level and high interest rate are something that Korea is not so fond of with harsh memory of defaulting less than two decades ago. There has been government measures to mitigate mortgage loan by directly bailing out some of highly distressed households, but this has not been so popular for many people on the ground of moral hazard. Also, such high spending is a good vulnerable points for either political parties. Although current level of debt is of course not as bad as the level during the Asian financial crisis in 1996, but it is something to keep in mind over time. Considering that it is the large bandwidth of middle class in Korea that holds mortgage debt, this could arise as a serious problem.

Screen Shot 2014-04-19 at 3.05.25 PM (Source: here)

Another thing I would like to point out briefly is the trends of disinflation, and elongated times of inflation rate. With target band between 2.5% and 3.5%, the 1.3% Korea has right now may be not so satisfying. With inflation rate going down, monetary policy instrument may be eroding its power, at least less than it could fully have. I don’t think it is at a worrisome level just yet at nominal interest rate still at 2.5%, but this is another sensitive spot for Korea.

Although Korea is number four economy in its geographical region of East Asia, it should be still considered as a “small economy.” Yes, it experienced very high growth and despite hardships in the past had came out of its crises at a record speed, the economy is still very vulnerable to financial market around the world. After having such a bitter experience in 1996, Korea’s financial market is one of the most heavily regulated market in East Asia. I personally think in order for Korea to truly grow, it should allow financial sector to grow as a stronghold for the entire economy to fare well.

South Korea worries over interest rate hike

Following from a recent news about South Korea’s exchange rate and its record high appreciation since 2008, I want to talk about the general threat that Korea may face in the near future.

According to South Korea Finance Minister Hyun Oh Seok, interest rate rise might pose great threat at home. South Korea have generally fared well despite 2008 financial crisis and Euro zone debt crisis. Just to see few data on inflation control and interest rate;

Screen Shot 2014-04-12 at 12.22.54 PM Screen Shot 2014-04-12 at 12.43.25 PM

We see that there was a huge drop in nominal interest rate from above 5% down to 2%, and at the same time inflation dropped at about the same rate. As a result, the real interest had little influence. This abled Korea to control capital in/outflow and thusly export. Because of lack of much natural resource endowments, Korea is quite dependent on its exports. one of the characteristics that Korean economy shows is that many exports are highly value added items with high technology. To name a few, cell phones, TV’s, naval engineering goods and automobiles.

As a result, in order for South Korea to be really stay on its competitive edge requires favorable financial conditions, especially those regarding exchange rates and interest rates. So, what happened to Korea in the past few months? There has been a huge appreciation in Korean currency Won and many worry that this will be a head wind against its growth.

Screen Shot 2014-04-12 at 12.52.23 PM

 

Another big concern for Korea right now is climbing household debt level reaching its record high (see graph below) at a wrong time. The Fed is continuing to taper quantitative easing programs, and the talk of whether interest rate will increase sooner than anticipated will also play a role in markets other than that of US. Why Korea should really be worried is that most of household debt is tied to mortgage in floating interest rate. Consequently, if interest rate hike around the world could bring back up the interest rate in Korea, burden on household could cause a series of default.

High debt level and high interest rate are something that Korea is not so fond of with harsh memory of defaulting less than two decades ago. There has been government measures to mitigate mortgage loan by directly bailing out some of highly distressed households, but this has not been so popular for many people on the ground of moral hazard. These kind of approach is also very costly in political games.  Although current level of debt is of course not as bad as the level during the Asian financial crisis in 1996, but it is something to keep in mind over time.

Screen Shot 2014-04-12 at 12.39.39 PM

Another thing I would like to point out briefly is the recent low level of inflation. With target band between 2.5% and 3.5%, the 1.3% Korea has right now may be not so satisfying. Yes, Korea have endured quite well the recent financial crises around the world, but with inflation rate going down, monetary policy instrument may be eroding its power, at least less than it could fully have. I don’t think it is at a worrisome level just yet at nominal interest rate still at 2.5%, but this is another side that Korea should really keep in mind for the next few years.

Although Korea is number four economy in its geographical region of East Asia, it should be still considered as a “small economy.” Yes, it experienced very high growth and despite hardships in the past had came out of its crises at a record speed, the economy is still very vulnerable to financial market around the world. After having such a bitter experience in 1996, Korea’s financial market is one of the most heavily regulated market in East Asia. However, I think in order for Korea to truly grow, it should allow financial sector to grow organically.

 

(Revised Cont.)China widen yuan’s trading band: a signal for economic overhaul

In my last post, I talked about the recent news on WSJ that China central bank engineered a depreciation of yuan against dollar, and then widen trading band for yuan from 1% to 2%. This unusual move has scared away investors that used to see yuan as a safety nest. I also talked about the motivation for China to do so is counterintuitive—not to help exporter by depreciating yuan, but to shake out hot money that has been irritating PBOC for the past few years. Now I would elaborate on why this is beneficial to China by shaking out hot money from the system and how it coincide with China’s other economic and financial reform.

According to the trinity in international financial theory, it is impossible to have all three of the following at the same time:

Impossible_trinity_diagram.svg

1. A fixed exchange rate (In our case, we could roughly view China as implementing fixed exchange rate regime, where the rate is managed to move within 1% for a short time span.)

2. Free capital movement (Investing in Chinese capital market is exclusive to limited amount of qualified foreign institutional investors)

3. Independence of monetary policy.

Historically, China has given up free capital movement in order to maintain independence of monetary policy and relatively stable exchange rate. However, the balance was breached since 2008, as hot money flowing into China through unconventional channel. Predictably, China had to give up either independent monetary policy or exchange rate manipulation.

The consequence is that China was forced to give up independence of monetary policy.  In countering the upward pressure on Yuan caused by hot money inflow, PBOC intervened in the Forex market, sucking up extra dollars and injecting excess liquidity into domestic economy. As a result, inflation rises. PBOC could either raise interest rate to combat inflation and protect consumption, hold interest rate as is and protect investment. What to do, what to do, here is what China do. The government would protect investment, given the larger contribution of investment to GDP. Therefore more often we see inflation skyrocketing and housing price soaring. I lament for the vast and poor Chinese people that are facing an ever-increasing inflation.  No wander why consumption only accounts for a small fraction of GDP.

Fortunately, we are having at least some hope of seeing this end as Chinese leadership announced reformation towards a more liberalized Forex market.

Widen trading band is inline with the ultimate goal of creating a consumption-driven economy, rather than exports or investment driving. By widen trading band, China was as if announcing that hot money will no longer be safe here, because Yuan could go either up or down with higher fluctuation. As hot money withdrawing, loosing hold on Yuan will help PBOC focusing more on domestic monetary policy. PBOC will also reduce the need for currency intervention, because as the Yuan’s floating range gets bigger, it won’t touch the upper or lower limit of the band as frequently as it has, thereby lessening the central bank’s perceived need to meddle in the currency market. As a result, the PBOC is expected to issue fewer Yuan for exchange-rate intervention, and that could alleviate inflation pressure. I hope that Chinese official will continue unwinding other economy reform that generates more long-term benefits and a sustainable growth.

 

(Revised) China widen yuan’s trading band: a signal for economic overhaul

Finally Chinese central bankers are making really beneficial policy. It was a very clever move for People’s Bank of China (PBOC) to widen trading band of Yuan to 2% from 1%, a move that help China shake out hot money from its financial system, improving effectiveness of monetary policy. What do I mean by this?

For many who may not know about exchange rate regime in China, here is some background information. China is one of the very few peculiar countries using “managed floating exchange rate regime”. The key word here is “managed”, which means PBOC set daily peg for trading of the Yuan against the U.S. dollar (a.k.a. the parity rate, albeit the fact that this rate is not market determined). Trading price for a day cannot exceed 1% above or below the parity rate. If the price ever exceeded this band, the PBOC would step in to intervene the market. This is very much like OMO intervene in the federal funds market to make sure effective fed fund rate move around the target rate.

Early in March, PBOC announced it would widen trading band to 2%. This might not sound like much, but as little as 1% has significant impact on the Forex market. You could see one of the reactions to this is that the yuan fell to its lowest level in 10 months, sparking paper losses estimated in the billions of dollars on leveraged bets that the currency would keep appreciating. Individual and institutional investors have been piling up options that would magnify gains when Yuan appreciate but would also cause more losses if the Yuan fall below a certain level.

Why dose PBOC doing this to poor investors? Well, as the saying goes, there is no free lunch, at least permanently.

Since 2005, Yuan has been appreciating steadily, with volatility as narrow as 1%. What other investment could yield better than betting on appreciating Yuan? While QE causing investments in U.S unpalatable, and debt crisis steering money away from EU, international capital seeks a new place to rest. China, with double benefits of high interest rate and appreciating Yuan, becomes the best option.

While international investors are happy about their new discovery, Chinese people are paying the bill. The influx of speculative capital has complicated China’s efforts to manage the economy, contributing to property bubbles and injecting excess cash into the financial system.

What should China and Chinese government do about this? There was no sign of change for years until just now.

Riding on the tide of economic and financial overhauls initiated by Chinese top officials earlier this year, PBOC finally move to depreciate Yuan and widen trading band.

Many people misinterpreted this move as the central bank trying to help Chinese exporters by lowering the price for their goods internationally. However, given the context, this is very unlikely. Chinese government had stated explicitly that the economic reform would include less intervention of exchange rate and export market. Relying on the old model of propelling the economy growth is no longer an option. Therefore, fueling exports is not the motivation behind PBOC’s unexpected move.

According to central bank officials, the PBOC’s attempts were aimed at thwarting short-term speculators betting on the yuan’s continued rise and introducing greater two-way volatility into its trading, as the bank was preparing for expanding the trading band.  And widening the band now shows that “the central bank is pretty satisfied with the effort to punish speculators,” a PBOC official said.

But punishing speculators apparently is not the ultimate goal. Why is this beneficial in the long run to China by shaking out hot money from the system? How is this move coincides with China’s other economic reform? I will talk more about this in my next post.

Venezuela’s first step

Venezuela is a nation is turmoil.  The media, as well as our class blog, have highlighted the on going violence and shortages. Many feel that this is a result of the capital controls put in by the socialist regime of Hugo Chavez. By loosening the capital controls on Monday, the Venezuelan government is taking a step in the right direction.  However Venezuela has a long way to go, and further progress requires further action.

Venezuela is one of the largest petroleum exporters in the world.  It seems absurd to think that there is a food shortage.  Yet the country depends heavily on the imports for its food, and the balance of trade is misleading due the heavy influence of oil exports.  In the past, in order to curb capital flight, the regime of Hugo Chavez put in place strict capital controls to keep money in the country.  The ramifications of these actions are being witnessed today.   Many importers lack the currency to secure imports due to capital controls.

The government of Venezuela has taken action.  As reported in the Wall Street Journal, the currency controls are being removed, allowing the currency to float on the open market.  Lifting the currency controls is hoped to have the effect of clearing up the shortages, alleviating the social unrest.  However it could also devalue the currency, causing inflation.

This can be seen in the short-run international finance diagrams. Upon the removal of the controls, the devaluation would come as a result of a shift in the Net Capital Outflows curve to the right, which has the effect of decreasing the value of the currency relative to the other countries (in this case the US dollar), shown in the currency diagram.

The most obvious way to fight inflation is to raise interest rates.  But raising interest rates enough to counter the inflation may be unfeasible and/or undesirable given the current economic situation.  A similar effect could be achieved if Venezuela had increased foreign investment.  To this, the country should remove laws that limit foreign investment and property rights that where implemented by Chavez.  In addition, Venezuela should consider leasing some of its oil and natural gas resources to foreign companies, as it did before the industry was nationalized in 1973.  By increasing foreign investment, Venezuela can shift the NCO curve back without messing with interest rates, as well as generating some badly needed revenue for a cash-strapped country.

Considering the natural resources that Venezuela has, it is surprising to see the situation as bad as it is.  The situation seems to be largely due to bad economic policy.  Capital controls, nationalization, and weak property rights have not proven to be sustainable economic policies.  Venezuela’s decision to lift its capital controls should be followed by further “free market” policies rectifying the above problems.

Cooling down hot money: China widen Yuan trading band (Cont.)

In my last post, I talked about the recent headline on WSJ of China central bank engineered a depreciation of yuan against dollar, and then widen trading band for yuan from 1% to 2%. This unusual move has scared away investors that used to saw yuan as a safety nest. I also talked about the motivation for China to do so is counterintuitive—not to help exporter by depreciating yuan, but to shake out extra hot money that has irritated PBOC for the past few years. Now I would elaborate on why this is beneficial to China by shaking out hot money from the system and how it coincide with China’s other economic and financial reform.

According to the impossible trinity in international financial theory, it is impossible to have all three of the following at the same time:

Impossible_trinity_diagram.svg

1. A fixed exchange rate (In our case, we could roughly replace the term with managed floating exchange rate regime of China. You could view this regime in which the exchange rate is fixed in a small time span)

2. Free capital movement (Absence of capital controls.In China, legal capital investment are only limited to certain qualified foreign investors)

3. Independence of monetary policy.

In China, in order to maintain independence of monetary policy and relatively stable foreign exchange rate, China has to limit the free capital inflow. However, the balance has been breached since hot money flowing into China through unconventional channel. To maintain the exchange rate, China has been countering the upward pressure on Yuan caused by hot money inflow through intervening in the forex market, sucking up extra dollars and injecting into domestic market excess liquidity. The consequence is that China were forced to give up independence of monetary policy. PBOC would either be forced to rise interest rate to combat inflation and encourage consumption, or to leave inflation as is by holding interest rate level and encourage investment. What is more often the case is that the government would protect investment, since this is the leading contributor of Chinese GDP. Therefore more often we see inflation in China skyrocketing and real estate market bubbling. I lament for the vast and poor Chinese people that are facing an ever-increasing inflation.  No wander why consumption only accounts for a small fraction of GDP.

Fortunately, we are having at least some hope of seeing this end as Chinese leadership announced reformation. And the signal is a more liberalized forex market.

Widen of trading band is inline with the overall goal of creating a consumer-driven economy, rather than one that relies on exports or capital-intensive industries. By widen trading band, China is as if announced to the world that there will be no more free money, as Yuan could go either up or down with higher fluctuation. At the same time of international capital withdrawing, loosing hold on Yuan will help the PBOC focus more on domestic monetary policy while reducing the need for currency intervention. That is because as the yuan’s floating range gets bigger, it won’t touch the upper or lower limit of the band as frequently as it has, thereby lessening the central bank’s perceived need to meddle in the currency market.

As a result, the PBOC is expected to issue fewer yuan for the purpose of exchange-rate intervention, and that could alleviate inflation pressure. Consumption, would therefore be encouraged. And as hot money being shaking out of the market, real-estate price will also be more affordable for Chinese consumers. I hope that Chinese official will continue unwinding other economy reform that generate more long-term benefits and a sustainable growth.

Cooling down hot money: China widen Yuan trading band.

Finally Chinese Central banker are making some real beneficial policy. I think it is a very clever move for PBOC to widen its trading band of Yuan to 2% from 1%, as this really help Chinese economy shake out hot money from the financial system, thereby improving effectiveness of monetary policy. What do I mean by this?

For many who may not know about Chinese exchange rate regime: China is one of the very few peculiar country using “managed floating exchange rate”. The key word here is “managed”, which means People’s Bank of China set daily peg for trading of the yuan against the U.S. dollar (a.k.a. the parity rate, albeit the fact that this is not market determined). Then the trading would start for the day where price cannot exceed 1% above or below the parity rate. If the price ever exceed this band, then the PBOC would step in and intervene the market.

Last Saturday, PBOC announced it would let the trading range widen to 2%. This might not sound like much, but as little as 1% has significant influence in the forex market. You could see a reaction to this is that the yuan fell to its lowest level in 10 months, sparking paper losses estimated in the billions of dollars on leveraged bets that the currency would keep appreciating. Individual and institutional investors have been piling up options that would magnified gains when yuan was appreciating but also causing more losses if the yuan falls below a certain level.

Why is PBOC doing this to the poor investors? Well, as the saying goes, there is no free lunch.

Since 2005, the Yuan is appreciating steadily and the trading band is as narrow as 1%, this allows a greater chance of winning if investor bet on appreciating yuan. As major financial market like U.S yielding low interest rate during QE and EU undergone debt crisis, investor seek alternative places to invest there money in. And China become one of the best options , because it not only offer high interest rate, but on top of that a double benefit of appreciating yuan. Many people concern that the central bank engineered a decline in the yuan’s value in order to help Chinese exporters by lowering the price for their goods internationally.  As I see it, this is very unlikely, since this would mean that the Chinese government is still relying on the old model of propelling the economy growth. Beijing had announced that it would implement economic and financial overhauls this year, including less intervention of exchange rate and export market. Therefore, fueling exports is not the motivation behind PBOC’s move of depreciating yuan and widen trading band.
According to central bank officials, the PBOC’s attempts were aimed at thwarting short-term speculators betting on the yuan’s continued rise and introducing greater two-way volatility into its trading, as the bank was preparing for expanding the trading band. The influx of speculative capital has complicated China’s efforts to manage the economy, contributing to property bubbles and injecting excess cash into the financial system.

Widening the band now shows that “the central bank is pretty satisfied with the effort to punish speculators,” a PBOC official said.

But I guess the bigger goal is more then to punish speculators. I will talk more about the benefit to China of increasing uncertainty of Yuan’s value and how it coincide with China’s other economic and financial reform.

Exporting Countries and Currency Pegging

As a continuation of discussion from class. I would like to go a little bit further on our analysis of currency and net exports. I want to focus mainly on China as the Chinese Yuan seems to be the issue that comes up again and again in both US and China.

On a detour to talking about China, let us first explore what other exporting countries are doing. To list a few, Germany, Russia South Korea, Singapore, UAE and Saudi Arabia are included in this list. We can find some common factors in this list. Although they are not fully listed here, most countries with large reserves tend to run surplus. Unless the country consumes more oil than it produces like US is doing, this is quite intuitive as oil and natural gas demand everywhere in the world. Other countries are almost exactly the opposite. They do not have such big endowments in natural resources, but they have competitive edge in a very focused industry or other technology that the rest of the world demands. Germany or Korea would fall under this category.

These countries are very sensitive to exchange rates. Take Korea for example.

MyChart (Data: World Bank)

 

Export of goods and services to GDP ratio takes up 57% of GDP on 2012 (import lingers around 50%). Export industry is a big part of Korean economy and is very sensitive to even the slight changes in exchange rates. Any sudden increase in exchange rates will have enough power to scare people and voice their worries.

Now, let us explore how exactly exchange rates influence these countries. Like we have discussed in class, net capital outflow which determines the supply of currencies in a given country, ultimately gives the the exchange rate. Suppose there is a monetary expansion in the Fed that lowers interest rate. Capital in the country will flee to other countries like Korea. In US, supply of dollar will increase, and the exchange rate will decrease. Lower exchange rate would mean that it is cheaper to buy American goods now for Koreans, and net export will increase as a result. As for Korea, there is a negative shock in NCO, which also influences the supply of KRW in a negative direction. Exchange rate for KRW / USD will increase and makes Korean goods seem more expansive for American consumers. Net export decrease for Korea as a result.

How is China coping with this situation then? China is pegging Yuan to the Dollar, meaning regardless of the shocks in the US’ capital inflow or outflow, China is maintaining the value of the exchange rate so that it is exporting at a very consistent level. China is able to do this because they are buying large amount of US treasury bonds to maintain the NCO level. China, the so called ‘factory of the world’, is exporting capital goods at a global scale and seemed to have chose the right strategy to rely on net export for growth motor. While it is completely impossible to peg Chinese Yuan to US dollars, China has been increasing the amount of swing in the exchange rate gradually. Rates have doubled on January 2012 from 0.5% to 1% and once again this year from 1% to 2%.

US has been complaining about the trade deficit with China for a long time. Although we do not know the true value of Yuan– at least not yet because they have been pegged to USD– China has been gradually reducing constraints on this matter. I personally think that China is taking its time to really detach itself from the exchange rate peg. High level of government surplus due to cultural habit of high savings rate adds to the NX disparity between US, but China is not willing to spend this money just not yet for export’s sake. After all, although their total GDP is quite high, China’s per capita GDP is not very close to any of the OECD members. Perhaps China will be more open to free floating rate once they deem themselves at a similar playing level with other countries.