The surprise devaluation of the yuan by the People’s Bank of China (PBOC) last month has drawn the ire of a number of senior U.S. lawmakers condemning the action as a blatant example of a long history of currency manipulation by China’s monetary authorities. But, despite the fact that a weaker yuan does indeed make Chinese exports more competitive, the move has been welcomed by the International Monetary Fund (IMF), which views the lower value of the yuan as more consistent with market fundamentals.
Additionally, if making exports more competitive through a devaluation of the currency is evidence of currency manipulation, then you could level a similar criticism against the United States for lowering the federal funds rate and the subsequent quantitative easing programs following the 2008 global financial crisis. Both tactics put downward pressure on the dollar and consequently the exchange rate, making U.S. exports more attractive against international competitors.
As it turns out, currency manipulation is not that easy to identify. As one Wall Street Journal blog post puts it, “Currency manipulation is not like pornography—you don’t know it when you think you see it.” Policy action that favorably affects a country's exchange rate—making exports more competitive—is not in itself evidence of currency manipulation. You also have to prove that the value of the currency is being held artificially below its true value. What’s the true value of a currency? That’s not easy to determine either.
Currency Manipulation – Why All the Fuss?
The recent devaluation of the yuan is being used to strengthen the case for some U.S. lawmakers and labor union officials that international trade agreements should cover exchange rate policies. While China is not part of the twelve-nation trade pact known as the Trans-Pacific Partnership (TPP), Japan, Malaysia and Singapore are, and all have been criticized for being currency manipulators.
Trade agreements are designed to reduce trade barriers between members of the agreement. Currency manipulation that artificially suppresses the value of a country’s currency vis-à-vis one’s trading partners’ currencies is effectively acting as a tariff on imports or a subsidy to exports. Either way, it makes one’s exports cheaper and hence relatively more competitive than trading partners’ exports.
That's why policies that deliberately make exports more competitive through a devaluation of the exchange rate are considered beggar-thy-neighbor policies because they help stimulate one’s economy at the expense of the economies of your trading partners. Yet, on these criteria, any expansionary monetary policy could easily be construed as evidence of currency manipulation. Let’s take a look at quantitative easing, for instance. (See also How Currency Enforcement Helped Sink the TPP.)
Quantitative Easing
Quantitative easing, while considered an unconventional monetary policy, is just an extension of the usual business of open market operations. Open market operations is the mechanism by which a central bank either expands or contracts the money supply through the buying or selling of government securities in the open market. The goal is to reach a specified target for short-term interest rates that will have an effect on all other interest rates within the economy.
While expansionary open market operations increase the money supply and decrease interest rates in an attempt to stimulate economic activity, the mechanism has limited effect when short-term interest rates are near or below zero. To lessen this ineffectiveness at the zero-bound, more unconventional methods of monetary policy need to be used such as quantitative easing, which targets commercial bank and private sector assets with much longer maturities. Quantitative easing occurs on a much larger scale than smaller scale, week-to-week open market operations.
Quantitative easing is meant to stimulate a sluggish economy when typical expansionary open market operations have failed. With an economy in recession and interest rates at the zero-bound, the Federal Reserve conducted three rounds of quantitative easing in 2009, 2010 and 2012, adding more than $3.5 trillion to its balance sheet by October 2014. Intended to stimulate the domestic economy, these stimulus measures had indirect affects on the exchange rate, putting downward pressure on the dollar.
Such pressure on the dollar wasn't totally negative in the eyes of U.S. policymakers since it would make exports relatively cheaper, which is another way to help stimulate the economy. However, the move came with criticisms from policymakers in other countries complaining that a weakened U.S. dollar was hurting their exports, as well as flooding their economies with excessive amounts of capital that could lead to bubbles in asset prices.
While the Federal Reserve was intentionally engaging in a monetary policy action that decreased the value of its currency, the intended effect was to lower domestic interest rates to encourage greater borrowing and, ultimately, greater spending. The indirect effect of a deterioration of the exchange rate is just the consequence of having a flexible exchange-rate regime. Some might argue that currency manipulation more appropriately describes the use of policy tools that directly affect exchange rates such as intervention in foreign exchange markets rather than indirectly affecting them. (See also Does Quantitative Easing Work?)
Foreign Exchange Intervention
Sometimes central banks will intervene in foreign exchange markets, which, unlike the monetary policy tool of quantitative easing, has a direct affect on exchange rates. However, while it's possible that such intervention is intended to artificially hold down the value of the currency to make exports more competitive, there are other reasons to take that course of action—foreign exchange intervention doesn't necessarily prove malicious currency intervention, either.
Many emerging markets intervene in foreign exchange markets to stabilize otherwise volatile exchange rates or to build up foreign exchange reserves as insurance in the face of currency pressures. While directly affecting the exchange rate, such policies aim at stability; they aren't necessarily about making exports more competitive.
So, while certain policy tools may be necessary conditions for identifying currency manipulation, they're far from sufficient. To obtain a sufficient condition, you need to be able to identify a policy tool that deliberately keeps and maintains a currency below its true value.
What’s the True Value of a Currency Anyway?
The IMF is often turned to for its expertise on exchange rates and while it prohibits its 188 member countries from manipulating their currencies in order to gain competitive advantages, the fund has never officially declared any country to be in violation of the prohibition. This is largely due to the fact that determining the true equilibrium value of a currency is nearly impossible to prove, with a variety of different valuation methods producing a variety of different possible exchange rate values.
In a report issued last year, the fund estimated that Japan’s yen in 2013 was anywhere from 15% overvalued to 15% undervalued. Apparently, determining the true value of a currency is not an exact science, making allegations of currency manipulation difficult to prove.
The Bottom Line
In theory, currency manipulation and a monetary policy like quantitative easing aren't the same thing; in practice, it's a lot more difficult to distinguish one from the other. While this doesn’t necessarily mean we should disregard currency manipulation as a meaningful concept, it does highlight some of the more biased views that are only recognized when some other country is doing the manipulating. So long as there are a number of viable competing interpretations on a currency’s relative value, it would be simply wrong to arbitrarily choose one over the others.
