26 August 2005

Exchange rates

Can someone explain to me how governments can “pin” currency exchange rates?

China's currency, the yuan, apparently remained pegged to the U.S. dollar for years. How did they manage this? It seems like it would be easy for a third party to arbitrage this arrangement to smithereens. Here's how.

Let's assume for the sake of argument that the "correct" exchange rate is 5 yuan = 1 usd (U.S. dollar). That is, on average, a nonperishable good that goes for 1 usd in America can be had for 5 yuan in China. Now let's say the Chinese government has, by government fiat, set 10 yuan = 1 usd. Here's my brilliant plan:

  1. Buy 500 yuan worth of stuff in China.
  2. Sell it for 100 usd in America.
  3. Pocket 50 usd.
  4. Take the other 50 usd and buy 500 yuan. You can do this at any bank that accepts the mandated exchange rate.
  5. Repeat until there's no more stuff left in China, or no more consumer demand in America, or no more room for dollars in your pockets, or (as seems most likely) the banks wise up and stop giving away yuan.

Net result, you get infinite dollars. Who loses? The manufacturer in China got a fair price, as did the consumer in America. Only the bank got ripped off. So why do banks go along with exchange rate controls?

There are only a few explanations I can see. First, this brilliant plan might be impossible because the friction is simply too much. That is, the bank charges a fee for changing your money; and it costs something to ship the stuff from China to America; and there are taxes and tariffs to be paid; and occasionally you'll buy something that you can't sell for whatever reason; and you have to employ people to do the work. Maybe it's just too expensive. But I don't believe it. If this were the case, there would be no international trade.

Second, maybe the Chinese government steps in to prevent people from running this scam. They could detect that you're spending too many yuan and revoke your business permits and such. I hear the rules involving bringing currency into China are incredibly involved, so maybe this is the case.

Third, the scam is self-limiting. The more it runs, the more it drives down U.S. prices. The lower U.S. prices get, the less attractive the scam is. Likewise, the scam drives prices up in China. That TV you're buying for 500 yuan and selling for 100 usd might cost 600 yuan next month (due to greater demand) and might only bring 75 usd in America (due to greater supply). These prices are much closer to the 10-to-1 exchange rate the Chinese government desired, and they make the scam much less profitable. But even with this explanation, the scam will still run; it just doesn't "go infinite". Undervalued yuan are still being pumped out of banks in exchange for dollars worth half as much.

Fourth, maybe supporting the mandated exchange rate is just a cost of doing business for banks in China. The government requires the banks to do it, at their own expense. In exchange, they're allowed do business in China. I don't see how this would be possible. The price tag is just ridiculous.

Fifth, maybe the Chinese government somehow taps into this cycle so that every time the scam runs, the government ends up with enough in its coffers to pay for all the money it's throwing away. In that case, the higher your tax rates, the more power you have to control exchange rates.

Sixth.... maybe this is what's actually happening. It would explain the ridiculous trade deficit between China and the U.S. But if so, the Chinese central bank is paying for it—right? So in that case, how is the trade deficit a bad thing for the U.S.? Sure, it hurts domestic manufacturing, but it's not like unemployment is out of control over here. And aren't we getting cheap stuff at China's expense?


mdj said...

They can do it because it's the government, for starters. Remember: paper money once upon a time represented specie. It's not that hard to peg currency to anything, and there's no reason its worth *has* to be essentially illusory (unless you argue the valuenessless of gold and silver to basic survival).

Your plan doesn't work for a couple of reasons, one of them being the 100% tarriff and other trade restrictions pegged on a lot of Chinese goods. However, as it turns out, some people are doing that. (Anecdotal Evidence Ahead) A friend of mine works in the Finance/Investment sector and a they invested in an operation very similar to this: Grabbing wiggits from china at cut rate prices, paying the tarriff, then selling them in the us.

When I tell you that wigit = kitchen sink, maybe you'll see why everyone isn't involved in the East India Wigit company. The cost and logistical complexity of moving kitchen sinks across the pacific ocean is beyond the scope of your average huckster, even assuming you avoid fuel costs with your nuclear air craft carrier.

jto said...

It's not that hard to peg currency to anything...

If you just arbitrarily do that, the tendency is for inflation or deflation to counteract (mostly) the change you've made.

Suppose in the Republic of Prestonia, the unit of currency is the Prestonian Bottle Cap, which is pegged to the dollar at 1 PBC = 1 USD. All trade in the Republic is done in bottle caps. Now the Emperor wants to spur exports, so he issues a dictum: the exchange rate is hereby changed to 5 PBC = 1 USD.

What happens? Two immediate effects: (1) All PBC prices instantly quintuple. (2) The sheer weirdness throws people for a loop and makes them wary of Prestonia and the PBC.

Inflation has well-understood consequences; let's set them aside. (Anyone with PBC savings or wages is extremely sad; PBC debtors and renters are very happy.) Does this change have the desired effect? Are Made-In-Prestonia goods actually cheaper for Americans to buy as a result?

No. The Emperor learns a valuable lesson: you can't just peg a currency to whatever you want. Or rather, you can, but it doesn't do anything particularly useful (unless you have debt, I guess).

China, though, (the whole news universe wants me to believe) has managed to devalue its currency relative to the rest of the world without triggering inflation. The only explanation I can imagine is that China's economy is walled off a lot better than I would've guessed.