How China's monetary policy drives world commodity prices
In order to cool off the strong pace of economic activity, on Thursday April 27, China's central bank raised the one-year lending rate by 0.27% to 5.85%. The Chinese central bank tightening of the interest rate stance has unsettled world commodity markets that for the past five years have been displaying spectacular performance.
For instance, the price of oil rose from US$19.5 per barrel in November 2001 to US$75 per barrel in April this year – an increase of 284.6%. The LME price of copper jumped to $7,147 per tonne in April – an increase of 425% since October 2001. During that period the price of zinc increased by 346% whilst the price of gold rose to US$653/oz in April from US$257/oz in March 2001-an increase of 154%.
It seems that the stance of China's monetary policy is of crucial importance in driving world commodity prices. The key mechanism behind this is the combination of aggressive monetary expansion and the almost unchanged rate of exchange against the US$.
How monetary pumping and the rigid exchange rate drive commodity prices
Based on the huge trade surplus with the US, which stood at $114 bill in 2005, most analysts have concluded that the current rate of exchange of 8.017 Yuan to the US$ is far too high. However, what matters for the currency rate of exchange is the pace of money expansion relative to real economic growth--not the state of the trade account.
After falling to negative 1.2% in March 2001 the yearly rate of growth of the central bank balance sheet (monetary pumping) relative to real economic activity climbed to 28.2% in September 2005. In February this year the yearly rate of growth of the relative pumping stood at 22.1%. In contrast, the yearly rate of growth of the Fed's balance sheet in relation to real economic activity fell from 11.6% in September 2001 to 0.9% in March this year.
Since China's monetary expansion relative to real economic activity has been accelerating whilst in the US relative pumping has been decelerating, it follows that China's Yuan has to depreciate against the US$. Yet the Chinese central bank kept the Yuan unchanged against the US$ at 8.29 between December 96 to June 2005.
Now, the massive monetary expansion has given rise to a strong demand for capital goods (in order to expand the infrastructure). This in turn has lifted the demand for raw materials and oil. Under normal conditions if the exchange rate had been allowed to freely fluctuate the monetary pumping would have raised the price of dollars in terms of the Yuan, thereby making the employment of various imported raw materials not a profitable proposition.
However, once the exchange rate is kept unchanged then things become somewhat different. The unchanged rate of exchange in fact reinforces the growing demand for raw materials. Keeping the rate of exchange unchanged whilst lowering the internal purchasing power of money through monetary pumping makes US$ priced goods relatively less expensive for the holders of the Yuan.
What allows the China's central bank to sell US dollars at a subsidised rate is the massive stock of foreign reserves, which stood at US$875 billion in March this year versus US$169 billion in January 2001.
By directing its demand to US dollar priced commodities China has significantly contributed to their overvaluation versus other goods and services priced in US dollar. (Whilst China cannot print dollars and therefore lift prices of all the goods and services priced in US dollar it can push prices of some goods relative to other goods). If China were to appreciate its currency, as most experts advise, this, given loose money policy will only reinforce demand for commodities from China.
The recent hike in China's interest rate is not the prelude for more interest rates increases. Chinese authorities are unlikely to go "all the way" to cool off the rampant pace of money driven economic activity given the still high unemployment rate.
Unofficial estimates suggest that the urban jobless rate could be at above the 8% mark, whilst at least 150million people in rural areas are without work. In short, for the time being, the loose monetary stance is likely to stay intact. For the time being, the loose monetary policy of China will continue to provide strong support for commodity prices.
It is not possible to tell how long can China continue with its loose policy and rigid exchange rate. Sooner or later the music will stop on its own accord once the stock of foreign reserves begins to dwindle. For instance, an economic slowdown in the US could have a significant effect on China's stock of reserves on account of a fall in exports.
Comments (21)
The Chinese turn raw materials into export products. If their policy raises the percentage cost of their cost of raw materials much less than the value of the consumer good they sell to the U.S. then they will never run out of dollars.
Published: May 1, 2006 11:08 AM
Billwald, don't worry. Washington will just print more dollars to send to them.
Published: May 1, 2006 1:31 PM
At least now it is possible for individual investors to make macro bets. Use etf's to make lots of money. Can be on interest rates (TLT), gold (GLD), etc...
Published: May 1, 2006 3:58 PM
"Most experts", this is an understatement, have called for an appreciation of the yuan against the dollar because, they say, of the US trade deficit against China. "Since China's monetary expansion relative to real economic activity has been accelerating whilst in the US relative pumping has been decelerating, it follows that China's Yuan has to depreciate against the US$." I believe those "experts" have a lot to learn from Shostak and the Austrians.
Published: May 1, 2006 7:38 PM
Yes, the above article is very interesting, and I'm not sure what to make of it. If the Yuan was floated tomorrow, wouldn't it go up, not down?
In related news, all you hard money fan(atic)s are about to get what you want, but not quite in the way you expected. The value of the zinc contents of the American penny will soon reach (then surpass) the face value. Long live the zinc standard!
Published: May 1, 2006 8:04 PM
What the artical suggests is the Yuan like the dollar is the basic unit of debt.
Which means that China is borrowing against it's own future. Big deal?
Published: May 2, 2006 5:37 AM
Frank,
I am having a tough time with this article and I can hardly believe I am following it correctly. If I am following it, then either my understanding of the china-US trade situation is very wrong, or this article is at least partially mistaken or misleading.
First of all, I am deriving from this article that you think that the yuan is presently artificially over-valued rather than undervalued in terms of US exchange and has been since at least 2001. Secondly, I take from the article that this has resulted in an artificially high Chinese demand for American exports or at least exports of commodities denominated in US dollars. Thirdly, the article seems to explain how this artificially high valuation of the yuan is manufactured via the Chinese central bank, subsidizing and propping the yuan by utilizing (and supposedly depleting) its huge reserve of US dollars that the Chinese central bank possesses “which stood at US$875 billion in March this year versus US$169 billion in January 2001�. In sum, the article seems to say that it has been a combination of monetary inflation of the yuan, in conjunction with this artificial over-evaluation of the yuan in US exchange, that has caused the increase in Chinese demand for commodities, and hence the increased price of these commodities in terms of US dollars.
Although I agree wholeheartedly that the yuan has suffered inflation as has the USD, I disagree pretty strongly with your assessment of which way the peg has influenced the yuan-USD exchange rate. Firstly, I would suggest that the yuan is presently undervalued with respect to the USD, and has been for the entire period of time since 2001. The basis on which I make this conclusion is in fact summarized in the statistic you cite of the Chinese central bank’s amazing increase in USD reserves of a whopping $700 billion USDs over that time. I don’t know how else anyone can explain such an incredible build-up of US exchange into the coffers of one nation’s central bank other than by that central bank systematically paying an inflated and subsidized price in terms of yuan for the USD. In other words, by keeping the yuan artificially cheap.
This has been an artificial subsidy to and therefore has caused an increase in Chinese exports to the US, at the expense of Chinese imports from the US (ignoring the massive Chinese import of the USD itself). This cannot be the result of an artificial over-valuation of the yuan by the Chinese central bank. It must have come about through an artificial devaluation.
If, on the other hand, what you are suggesting is that the Chinese central bank has at some recent point in history, had a MASSIVE change in policy and is NOW starting to pour its massive reserves of USDs that it has accumulated since 2001 into the acquisition of specific dollar denominated commodities and raw materials, then I could go along with that. But that doesn’t seem to be quite what you’re saying. Would you mind clarifying?
Published: May 2, 2006 6:42 PM
Dear Paul,
I agree that one needs to provide an explanation for the huge stock of reserves China has accumulated. I suspect that this can be explained by the fact that China moved away from a Soviet type economy. So this transition has given boost to the generation of real wealth, which was directed towards exports - a mercantilistic type policy. On account of still cheap labour China could get away with this policy. However, I suspect that this is getting now much harder given that the cost of labour also there is starting to go up. Irrespective of the state of reserves and the trade account what matters for the currency rate determination is the relative scarcity of money. Given the fact that China's money printer has been working much faster than its American counterpart in my book it must mean that the Yuan should depreciate and not appreciate against the US$.
Another point that I want to add is that rises in foreign reserves and the currency rate of exchange are not related as such. Take for instance Japan. The rate of exchange with the US$ stood at 358 yen in early 1971 whilst the stock of foreign reserves stood at $3.2 billion. By 1987.4 the yen stood at 139.5 - appreciated against the dollar, yet the reserves jumped to $62.9 billion. In 2004.12 the yen stood at 102.5 whilst reserves climbed to 819 billion dollars.
All the best,
Frank Shostak
Published: May 2, 2006 8:00 PM
Hi Paul,
I completely agree with Franks article, so based on that he probably is wrong ..Laugh ...only joking.
Seriously though, Franks article is consistent with the hazzards of fixed exchange rates and why under these conditions loose monetary / fiscal policy is a recipe for disaster.
Another reason for me why the old "keep em honest" Gold Standard is the only Monetary framework that places the appropriate checks and balances on rogue government / central bank behaviour.
Note, some people claim that commodity prices determine exchange rates. Personally, I don't actually know what determines EXrates, and I don't loose any sleep over it either.
Why the Yuan has not depreciated is anyones guess. But if there is any truth in the claim that commodity prices determine exchange rates its one possible reason I suppose - but I'm not convinced its that simple either.
it would depend on the import component embodied in Chinese exports, and a whole host of other determinants far beyond the scope of economic modelling - as I think you would agree.
Cheers.
Cheers.
Published: May 3, 2006 12:55 AM
Hi Paul,
I completely agree with Franks article, so based on that he probably is wrong ..Laugh ...only joking.
Seriously though, Franks article is consistent with the hazzards of fixed exchange rates and why under these conditions loose monetary / fiscal policy is a recipe for disaster.
Another reason for me why the old "keep em honest" Gold Standard is the only Monetary framework that places the appropriate checks and balances on rogue government / central bank behaviour.
Note, some people claim that commodity prices determine exchange rates. Personally, I don't actually know what determines EXrates, and I don't loose any sleep over it either.
Why the Yuan has not depreciated is anyones guess. But if there is any truth in the claim that commodity prices determine exchange rates its one possible reason I suppose - but I'm not convinced its that simple either.
it would depend on the import component embodied in Chinese exports, and a whole host of other determinants far beyond the scope of economic modelling - as I think you would agree.
Cheers.
Cheers.
Published: May 3, 2006 12:56 AM
Thanks for that response Frank.
“I agree that one needs to provide an explanation for the huge stock of reserves China has accumulated. I suspect that this can be explained by the fact that China moved away from a Soviet type economy. So this transition has given boost to the generation of real wealth, which was directed towards exports - a mercantilistic type policy.�
But which mercantilist policy? What policy could the Chinese authorities implement that could achieve the result of strong exports to the US, and a buildup of USD in their coffers: Chinese import tariffs and loans of Yuan to the US? This could subsidize exports to the US, but it could not account for the vast increase in USD reserves held by the Chinese central bank. The only explanation seems to be that the Yuan has been undervalued during this time. This explains both the Chinese export subsidy, and the buildup of USD reserves in the Chinese central bank.
“On account of still cheap labour China could get away with this policy.�
I would argue that the cheap Chinese labor is a symptom of other particular causes, rather than a cause or contributor of this particular effect. In other words, the labour is cheap because the overall productivity of labour there is still very low; that is, the capital invested per capita in china is still very low. It is hard to see how this fact can influence a great buildup of USD reserves with the Chinese central government. With no peg, and all other things being equal, there should be no artificial tendency for a buildup of USD in china, but rather, the markets would adjust exchange ratios in accordance with the respective currency purchasing power, and a more balanced volume of US products would flow back to china in exchange for Chinese goods.
“However, I suspect that this is getting now much harder given that the cost of labour also there is starting to go up.�
Similarly, I don’t believe this should play any role in a lessening of a buildup of USD in Chinese central bank coffers. An increase in real wages to Chinese labor again, represents simply an increase in capital invested per capita and the necessary increase in the productivity of labor there. i.e. more chinese products, better, cheaper to sell at home and abroad.
“Irrespective of the state of reserves and the trade account what matters for the currency rate determination is the relative scarcity of money [and hence their respective purchasing powers].�
This is certainly very relevant and true when we discuss freely floating currencies. However, it seems of no use to claim this when we know the Chinese central bank is pegging the Yuan to the dollar irrespective of the currencies’ relative purchasing powers. In this case, since the peg is fact, the question is whose currency has more purchasing power and hence is being artificially devalued.
“Given the fact that China's money printer has been working much faster than its American counterpart in my book it must mean that the Yuan should depreciate and not appreciate against the US$.�
Perhaps the Yuan is depreciating at a faster rate than the US. But the question remains what their relative purchasing powers are, and what has been their relative purchasing power over the last five years. I would argue that over this time, the Chinese Yuan purchasing power has been superior over that time, that the Yuan has been artificially pegged cheap against the USD, and that the Chinese central bank had to build up massive reserves in USD in the process of buying USD at an inflated price in terms of the Yuan to maintain this peg and keep the Yuan cheap.
“Another point that I want to add is that rises in foreign reserves and the currency rate of exchange are not related as such.�
This is true if the currencies are not pegged, or perhaps if the peg very nearly approximates the market exchange rate. I don’t think it is true when the peg plays a significant role in the exchange rate.
“Take for instance Japan. The rate of exchange with the US$ stood at 358 yen in early 1971 whilst the stock of foreign reserves stood at $3.2 billion. By 1987.4 the yen stood at 139.5 - appreciated against the dollar, yet the reserves jumped to $62.9 billion. In 2004.12 the yen stood at 102.5 whilst reserves climbed to 819 billion dollars.�
The Japanese were not pegging the yen to the dollar. Therefore, there is no necessity for Japan’s central bank to buildup or divest itself of large sums of USD over that time in the pursuit of an artificial peg. So I agree, in this case, there should be no necessary correlation between exchange rates and foreign reserves.
Published: May 3, 2006 2:23 AM
Hi Alan,
“I completely agree with Franks article, so based on that he probably is wrong ..Laugh ...only joking.�
I am with you. I feel uncomfortable disputing Frank because he is very knowledgeable and I am prone to error. On the other hand, if I don’t put up an argument, I may not learn or see what I’m missing, so I barge on and hope to see some light.
“Seriously though, Franks article is consistent with the hazzards of fixed exchange rates and why under these conditions loose monetary / fiscal policy is a recipe for disaster.�
You’ll get no disagreement on that from me.
“Another reason for me why the old "keep em honest" Gold Standard is the only Monetary framework that places the appropriate checks and balances on rogue government / central bank behaviour.�
Absolutely.
“Note, some people claim that commodity prices determine exchange rates. Personally, I don't actually know what determines EXrates, and I don't loose any sleep over it either.�
Assuming no central bank intervention with the explicit intent of pegging their currency to another, the international markets such as the bourse will speculatively provide an arbitrage function, estimating and bidding currencies up and down according to their relative expected purchasing powers and in this way, roughly arrive at exchange ratios that match purchasing powers of the currencies.
“Why the Yuan has not depreciated is anyones guess.�
Well this much we know for a certainty: the Chinese central bank is busy intervening in the markets paying a fixed price for US dollars in terms of Yuan and restricting trade in Yuan outside of its influence.
“But if there is any truth in the claim that commodity prices determine exchange rates its one possible reason I suppose - but I'm not convinced its that simple either.�
I think it is fundamentally pretty simple: if markets are allowed to respond to changing purchasing powers of various currencies, the market will tend to level these purchasing powers by bidding up and down exchange rates. If this is prevented, then the imbalance in purchasing powers will tend to cause an imbalance in trade, and a buildup of foreign exchange in a central bank’s coffers.
�it would depend on the import component embodied in Chinese exports, and a whole host of other determinants far beyond the scope of economic modelling - as I think you would agree.�
Thank God Austrians don’t have to perform economic modeling to understand economics.
Published: May 3, 2006 2:45 AM
Thanks Paul,
I agree that it is very tricky to know whether the price of US$ in Yuan terms is too low or too high. But one thing we do know that China’s money printer has been working much faster than its American counterpart. This at least can inform us that on a relative basis the purchasing power of the Yuan versus the purchasing power of the US$ has been under downward pressure. So this information is sufficient to draw the conclusion that rapid monetary inflation in relation to real goods in China relative to US money inflation in relation to real goods coupled with the fixed exchange rate has given an important incentive for the import of raw materials. This conclusion doesn’t require establishing how China managed to accumulate the vast stock of foreign reserves. From this one can also conclude that if loose monetary policy stays intact the appreciation of the Yuan, as many experts suggest, will only give more incentives for China’s importers of raw materials.
All the best,
Frank Shostak
Published: May 3, 2006 3:29 AM
Frank,
"But one thing we do know that China’s money printer has been working much faster than its American counterpart. This at least can inform us that on a relative basis the purchasing power of the Yuan versus the purchasing power of the US$ has been under downward pressure."
But aren't you neglecting the other factor in purchasing power, which is the goods side? Your statement assumes that the "total" quantities of goods in the U.S. and China have been growing at the same rate (puting aside measurement issues).
Since it seems much harder to have any idea about these "total" quantities of goods, I'd be tempted to conclude the Chinese central bank's build-up of dollar reserves is a stronger and more direct indicator of the real yuan/$ rate and, moreover, that Chinese output has simply been accelerating faster than has U.S. output. This is consistent with the presumptive liberalization of the Chinese economy over recent years.
Perhaps you view Chinese inflation as simply too large to be counter-balanced by any such goods side effects.
Published: May 3, 2006 12:51 PM
Hi Eric,
In my article I did say that I compare the pace of monetary pumping in relation to real economic activity in China against the pace of US monetary pumping in relation to US real economic activity. So I don't assume that China and US grow at the same pace - I use the available official data regarding real economic activity. It is quite possible that the data is wrong - but this is all that we have. Some commentators have suggested that China's official statistics regarding real economic activity could be on the high side. So in this case the relative increase in the monetary pumping versus real economic activity is likely to be even much higher.
All the best,
Frank Shostak
Published: May 3, 2006 4:34 PM
Starting an economy on the ground floor is not the same as an integrated economy near full capacity slowly evolving.
There is yet a scarcity of goods in China. Through more time, more factories will be brought on line. How to finance those factories in the absence of foreign investment but to issue more Yen backed by nothing as of yet?
Every business in China is winner at the moment and it will probably be some time before businesses have to compete for limited resources.
In light of that too much is being made of monetary growth vs productivity.
Published: May 3, 2006 4:51 PM
Thanks for the response, Frank. I see that you use inflation relative to GDP. I really don't have a good sense of how much to trust the GDP figure in this context, and I don't see how to get a good sense of it.
I guess my point is that given this choice of uncertainties (GDP/output measurement vs. how the Chinese dollar reserve can be maintained apart from pushing the yuan down), I'm more suspicious of the former.
Published: May 4, 2006 9:12 AM
Frank, I am also having a difficult time following this argument. At the risk of over-simplifying, I always assumed that: a) the Chinese central bank printed yuan and used them to buy dollars in order to lower the yuan vs. the dollar, and b) sold dollar reserves in exchange for yuan in order to raise the yuan vs. the dollar. By doing this, a peg was maintained.
This would seem to suggest that a continuous effort to prop up the yuan vs. the dollar would result in declining (and ultimately depletion of)dollar reserves. What am I missing?
Published: May 4, 2006 9:32 PM
Your post is full of useful ideas.
However, I am worried that the Western concept of monetary policy as used in your post does not fit perfectly in a country like China in which, at least until recently, the banking system has been under tight government control.
In the U.S.,for example, the Federal Reserve largely determines monetary policy by open market operations in which it buys government debt. The banking system distributes the resulting capital broadly in response to a free credit market.
In China, on the other hand, the central bank and the government could (and did) determine where loans were made. It is safe to infer that, starting a few years ago, the Chinese central bank (at government behest) directed the subordinate banking system to make loans available to credible manufacturers, especially manufacturers for export. The central bank then opened a discount window to purchase the resulting debt of the subordinate banks.
This move was similar to a loose monetary policy in the West -- capital was pushed into the economy as the central bank bought subordinate bank debt. However, there are also differences. The relative cost of manufactured goods was held down as capital flowed into this sector, and an enormous increase in exports brought in foreign currency.
Exporters now have debt in renminbi and pay wages in renminbi, but the flow of funds to pay these costs is in foreign currency. The central bank must, therefore, purchase foreign currency. An upward reevaluation of the renminbi tends to squeeze the exporters and the banks that supplied them with easy credit. Hence, changes in the relative value of the renminbi must be made with caution.
Some of these ideas are borrowed from kinkyeconomist.typepad.com
Published: May 6, 2006 12:01 PM
Frank,
I consider the major flaw in your analysis neglect of the possibility that the Chinese currency may have been undervalued throughout the five year period, regardless of the fact as to whether it should have been depreciating against the Dollar or not. It just means that the Chinese currency may be less undervalued today than it was 5 years ago. (Such a possibility would also account for the build-up of Chinese reserves with the implication that if the rest of your analysis holds up, that we can expect a slowing of build up of Chinese reserves in the future -ignoring the effects of any slowdown in the US economy). Such a slowdown is not, however, readily apparent over the 5 year period.
I therefore go along with the above critcisms (questions raised) and do not have much more to add on this point. However, there is another aspect that has been overlooked if we are to analyse this matter from an Austrian perspective - which to my mind does not just deal with one way cause and effect analyses, but has to go full circle taking into account economic interrelatednesses through time (something along the lines of Rothbard's ERE analysis, or the law that consumer prices determine factor prices and not the other way round because of considerations of "processes through time"). You claim that appreciation of the Chinese currency will only exarcebate matters by increasing Chinese demand for raw materials. This would be true only in the short term. In the long term (after working through an anlysis of "processes through time", the currency appreciation would choke off demand, i.e., less would be exported, particularly considering the openess (percentage of exports to GDP) of the Chinese economy, and the wherewithal to purchase even the "cheaper in local currency terms" commodities falls away (Chinese exporters will receive less Yuan for Dollars and the country's Dollar reserves will eventually dissipate as more importers cash in less Yuan for their country's Petrodollar reserves).
By including consideration of the relative strengths of China's export market and internal market (and one should incude an analysis of changes in the import component of exports to refine the analysis), I believe one can fruitfully come to understand the point at which the music will stop. For example, it is in the interests of the export sector to maintain an undervalued currency, but in the interests of the internal market to have an overvalued currency which would initially also help dampen local price inflation. As the internal market grows (and inflates), expect increasing political pressure from the "internal market interest groups". If US demand also falls despite the currency peg, exporters have less legs to stand on against such pressure. (For the refinement - import component of exports - as this rises, a stronger exchange rate matters less (as it did for Germany) as the rest of the world pays the same commodity prices anyway (assuming little time lag between individual imports and exports or exporters hedge their net exposures). The pioneering export industries, such as textiles and clothing have very low import components for which an undervalued currency increases the elaticity of supply - makes a lot more ventures profitable - relative to exports that have much higher import contents).
One would also need to take into account the dampening effect on prices of the capital overcapacities, which I believe are significant in China.
One thing that confuses me, and perhaps you can help me on this one, is your measure of Fed's balance sheet in relation to real economic activity, which shows a decline for the US in contradiction to money supply growth which everywhere I read appears to have increased over the five year period. How do you reconcile these two measures and why is Fed's balance sheet relative to real economic growth the more relavant measure? Furthermore, is it possible that the money supply (M3) can still grow even if the Fed's balance sheet goes down? (for example, is it not possible for loans to increase without showing up as an increase in Fed's balance sheet, perhaps by reducing reserve requirements?) I am of course assuming that US money supply growth has exceeded real economic growth over this period.
Published: May 6, 2006 1:19 PM
Frank,
I agree in general with what you have said here. In my view, eventually the PBoC is possibly going to take it in the shorts not only on its dollar reserves that it has accumulated while suppressing the value of the RMB, but on its investments made with those dollar reserves.
Published: March 5, 2007 5:37 PM