Exchange Rates

The Treasury's April foreign exchange report should be interesting. Thailand hasn't been included in past foreign exchange reports.  Yet it is likely to meet all three of the criteria set out in the Bennet Amendment for a finding of "manipulation." 

Korea didn’t stop the won from appreciating through 1090 (its intervention level in 2016); Taiwan seems to be blocking any move through 30.

One reason why headline GDP has increased by around 3 percent (q/q, annualized) in the last two quarters is that net exports contributed positively to growth. Not in any big way, but they contributed. That to be honest has surprised me. Going into the year I expected net exports to be more of a drag, for three reasons: Imports had been surprisingly weak in the first part of 2016, and I expected a bit of payback in the 2017 data. There is evidence—notably from the slow response to the dollar’s 2003 depreciation—that the trade response to a big exchange rate change now takes longer, and it can take up to three years to see the full effect. So I was expecting some additional drag from the dollar’s 2014 appreciation. The dollar rose strongly in q4-2016, and I expected that to have an impact. Broadly speaking, none of these three effects have played out quite as I expected. There was a bit of payback for weak import growth early in 2016 in q4-2016—and to a lesser degree in q1-2017. But in q1 the rise in imports was offset by a boost to exports. The impact of the 2014 dollar appreciation seems to have petered out, exports are rising again (though slowly). And the dollar’s late 2016 appreciation reversed over the spring and summer. At this stage there is no reason to think that the trade impact of the 2014 dollar move isn’t mostly, so to speak, already priced in. Three years have elapsed from the dollar’s big move in late 2014—and manufactured exports are about a percentage point of GDP lower now than they were in 2013.* So I no longer expect a large drag from trade if the dollar stays at roughly its current level,** though if the Fed keeps tightening ,the current account would deteriorate from the mechanical impact of a higher interest bill on the United States external debt. But the stability of the dollar at roughly its current level isn’t a sure thing. Any of three things could change: The Mexico peso could fall further, if NAFTA talks collapse and Trump gives notice of his intent to withdraw. The Chinese yuan’s current stability—both against the dollar and against the basket—might give way to a new bout of depreciation pressure should China’s growth falter, or should China proceed too quickly to liberalize its capital account (the needed prerequisites for an orderly liberalization of outflows in particular are not in place). The euro could reverse its 2017 appreciation, whether because the eurozone’s recovery falters and the market stops anticipating a future point when the ECB will start actually tightening (rather than doing a bit less easing) or because the market starts to expect more rapid tightening from the Fed. And, of course, the most obvious thing that could lead the market to anticipate a faster pace of monetary policy tightening—apart from a new Fed Chair—is a major change in U.S. fiscal policy, such as a large tax cut that boosts demand (albeit inefficiently) at a time when the economy doesn’t need a cyclical boost. * I do wonder if the lags on the export impact from dollar depreciation are longer than the lags on the impact of dollar appreciation, but that is a story for another time. ** I also tend to think that the dollar needs to depreciate slowly over time to keep the trade balance stable, but that is a separate effect.

The Trump Administration wants to bring down the U.S. trade deficit. A number of manufacturing-heavy Asian economies run sizable current account surpluses. Over the course of the summer, some of them were clearly intervening to keep their currencies from rising against the dollar. But, somewhat surprisingly, this hasn’t caught the attention of the Trump Administration. The latest Treasury foreign exchange report removed Taiwan from the Treasury watch list even though Taiwan intervened over the summer to keep the New Taiwan Dollar from rising (at the 30 Taiwan dollars to the U.S. dollar mark). The report didn’t display any noticeable irritation at Korea’s continued propensity to buy dollars to keep the won from strengthening through the 1100 Korean won to the dollar mark. Korea bought foreign exchange in July, before the North Korean missile crisis intensified. The report continues to ignore Thailand, even though Thailand comes very close to meeting all three of the Treasury’s stated criteria for identifying manipulators (a bilateral surplus with the U.S. of over $20 billion, an overall current account surplus of more than 3 percent and intervention in excess of two percent of GDP). And Singapore got yet another free pass. These countries, not China, are at the epicenter of the recent return of foreign exchange intervention in Asia. India and Indonesia have also intervened, but they get off because they run current account deficits.* If you think countries with large current account surpluses shouldn’t be intervening in the foreign exchange market to help keep their currencies weak, there is plenty to complain about right now—more so than at any time since the dollar’s late 2014 appreciation. The combined current account surplus of these smaller Asian economies ($250 billion) is up substantially from 2007, and for that matter from 2012. And practically speaking, currency moves have a fairly predictable impact on the trade balance—convincing a number of Asian countries to let their currencies appreciate would likely have a more significant impact on the U.S. trade deficit than Trump’s high profile attempts to renegotiate existing trade agreements.  Centering the Treasury’s report around the three criteria set out in the Bennet amendment has strengthened the report’s analytical underpinning. At times in the past the report veered a bit too far from actual developments in the foreign exchange market—particularly in its description of the policies of individual countries. But I suspect that applying the three criteria too mechanically creates problems of its own—not the least because it is relatively easy for a country that is paying attention to engineer around the reserve accumulation criteria. At risk of intervening too much? Get your social security fund to buy a bunch of foreign assets in a new “diversification” push. Or have the finance ministry issue local currency bonds to set up a sovereign wealth fund that will buy foreign exchange from the central bank on an ongoing basis. Or let your forward book rollover directly to your sovereign wealth fund. Or ask your state banks to buy foreign exchange and provide them with an (undisclosed) hedge. I didn’t make any of the examples above up. The irony is that the more experience a country has with intervention, the easier it often is to hide the intervention. Concretely, I think the Treasury should make five adjustments to the foreign exchange report. (1) Assess more countries against the Bennet criteria. This one is easy. Expand the report to the top twenty trading partners. And automatically assess any country with its own currency and a current account surplus of over 3 percent of GDP. There is no good reason why the foreign exchange report right now doesn’t cover Thailand—which is less than $1 billion dollars away from meeting all three Bennet criteria (its bilateral surplus with the U.S. is $19 billion and change). (2) Deemphasize the bilateral balance. This one is a little tricky. The Trump administration has made the bilateral balance a key measure of trade success (it isn’t, especially in a world where bilateral trade is often heavily motivated by tax concerns. The focus right now is on goods trade, but the bilateral services data is even more problematic: the U.S. runs a healthy services surplus with Ireland and the “UK Caribbean”).** And well, the bilateral balance criteria is mandated by Congress: the Treasury cannot legally toss it aside entirely. But the bilateral balance currently has the effect of letting some countries that should get more scrutiny off the hook. Taiwan for example. Its bilateral surplus with the U.S. doesn’t breach the $20 billion threshold even though its overall current account surplus easily tops 10 percent of its GDP. Taiwan produces a ton of semiconductors (some based on licensed designs, with the royalties paid—I would guess—in no small part to the offshore subsidiaries of U.S. multinationals for tax purposes; some based on Taiwanese intellectual property) that are sold to Chinese firms that assemble electronics for reexport. Taiwan’s value-added bilateral surplus is far higher than its reported bilateral surplus with the U.S. The same is true of Korea. Korea now exports more semiconductors than autos. But the bilateral trade data shows only limited U.S. imports of Korean semiconductors (and for that matter, only modest imports of smart phones). Korean electronic components are often assembled elsewhere for re-export globally. And making a deficit in bilateral trade one of the currency report’s three criteria has let Singapore permanently escape the scrutiny its heavy intervention deserves, as Singapore runs a bilateral surplus with the U.S.*** Singapore is small, but its currency policy has long set a bad example for its neighbors.  (3) Stop giving countries a free pass on a large existing stock of reserves. Right now the Treasury deducts estimated interest income on a country’s existing stock of reserves from its estimate of intervention. That has the effect of giving a country like Taiwan—with reserves equal to 80 percent if its GDP—a pass on reserve growth of about one percent of GDP, if not a bit more. In my view, countries with high levels of reserves and large current account surpluses should be encouraged to sell the interest income for domestic currency and in turn use the domestic currency to pay the interest on their sterilization instruments or to remit profits back to the finance ministry. In Taiwan and Korea that would provide a revenue stream that could be used, for example, to pay for expanded social insurance. Counting interest income toward the two percent reserve growth threshold also is a way of recognizing that a large stock of reserves from past intervention has an impact on the current account (as Dean Baker emphasizes) not just intervention today. (4) Do not ignore the exchange rate at which a country intervenes. At 1100 won to the dollar, Korea generally runs a large current account surplus globally, and will export a ton of autos to the U.S. At 900 won to the dollar, Korea ran a much more modest surplus globally, and Korean auto makers have a strong economic incentive to produce in the U.S. rather than in Korea. The right level of the won to the dollar of course depends a bit on Korea’s own economic conditions and a bit on the dollar’s overall strength or weakness. But if the won is being kept too weak against the dollar, it is likely to be too weak against most currencies most of the time. The Treasury currently just looks at the quantity of intervention, not the timing of the intervention – and it doesn’t assess whether a country is stepping into the market at the right or the wrong level. The Treasury’s October report, for example, lauds Korea for reducing its intervention (the lower level of intervention is a function of large sales last fall when the dollar was appreciating strongly and Korea faced significant political uncertainty, Korea has resisted appreciation pressure by buying dollars at various points this year). But last I checked, Korea continues to have a policy of intervening to block appreciation when the won approaches 1100. And intervening at 1100 is a step backward in the grand scheme of things. In the years before the crisis, Korea waited for the won to appreciate to 900 before intervening (that was Korea’s policy in 2006 and 2007) and at times after the crisis it has waited for the won to approach 1000 before stepping in (admittedly, the won only reached 1000 once, in 2014; Korea usually stepped in at the 1050 mark). Looking at objective criteria like the amount of intervention was meant to take subjective judgments about the “right” level of the currency out of the report. I don’t think it works. Intervention at the wrong level should be called out even if it isn't big enough to cross the "sanctionable" threshold, particularly in a context where the government is actively encouraging a broad range of domestic investors to buy foreign currency. (5) Stop ignoring shadow intervention (e.g. the accumulation of foreign assets by actors other than the central bank).**** Here is a prediction: China, Korea, Taiwan, and Japan will never “show” reserve growth in excess of two percent of GDP when they meet the other two criteria for being named. It is too easy to shift foreign exchange off the central bank’s balance sheet and onto the balance sheet of other state actors. Korea for example has decided to invest a large share of the assets of its national social security fund abroad (the national social security fund is already huge, and—thanks to Korea’s high contributions and miserly social benefits—adding rapidly to its assets). Call it diversification if you want. It clearly has had the effect of structurally reducing Korea’s need to intervene in the foreign exchange market. Japan’s government pension fund has a huge pool of domestic assets that it could sell (to the central bank) in order to invest abroad if Japan had reason to be concerned about yen strength. China’s Belt and Road Initiative was originally designed, in part, to help the PBOC reduce its headline reserve growth—though it has subsequently taken on a life of its own. And Taiwan has encouraged outflows from its life insurers on a rather massive scale. I would be a bit surprised if they don’t have an explicit or implicit hedge with the government. The growth in their holdings of foreign debt mechanically has explained how Taiwan has been able to keep its intervention limited even with a massive surplus. Taiwan's financial institutions now hold almost as much foreign debt as Taiwan's central bank, and clearly have been doing most of the recent buying.**** In many ways this is the right time to try to establish a new global norm, one where countries with large current account surpluses don’t intervene to block appreciation—or encourage their state institutions to diversity into foreign assets—to help keep the currency weak. Korea, Singapore, Taiwan and Thailand all have current account surpluses of over five percent of their GDP; Singapore, Taiwan and Thailand have current account surpluses of over ten percent of their GDP (over the last four quarters of data). Setting out the norm when most countries are in violation of it is difficult, practically speaking. Better to spell out it out ahead of time and give countries a chance to adjust. That’s why the October report was a missed opportunity. The Treasury took the heat off just when several countries should have been put on notice for their intervention over the summer. * Switzerland has intervened heavily at times this year too, but the euro’s recent appreciation has taken a bit of pressure off the Swiss National Bank. ** The bilateral services trade is in its own way quite interesting. The U.S. runs a massive bilateral services surplus with Ireland, and an (admittedly small) deficit with Germany (a world renowned center of service excellence obviously!). The U.S. runs a massive surplus with the UK Caribbean (primarily in financial services) and to my surprise, a massive deficit with Bermuda (it is all due to reinsurance). It also runs a surplus with places like Switzerland and Singapore. That is why I suspect the bilateral services trade data is even more distorted by tax considerations than the bilateral goods data. (country numbers are from the U.S. services trade data, table 2.3) *** I would guess in part for tax reasons. Singapore is a hub for petrol refining, pharmaceutical manufacturing, and semiconductor manufacturing and testing. And well, the import and and re-export of Australian iron, which clearly is tax-driven. **** In some countries, like Japan, the finance ministry manages the bulk of the country’s formal reserves. But even in these cases there are ways of shifting foreign asset accumulation to less scrutinized institutions. ***** Since 2011, "private" holdings of portfolio debt—according to Taiwan's net international investment position data—have increased from 35 to about 80 percent of Taiwan's GDP. That's a lot of foreign exchange risk for domestic institutions to hold.

Analysis of the September intervention proxies for China and q2 Chinese balance of payments data.

This is a guest post by Cole Frank, a research associate at the Council on Foreign Relations. China watchers are always looking for new ways to gauge capital flows and pressure on the yuan. The most reliable indicators—FX settlement data and the PBOC’s balance sheet—are monthly and thus don’t shed light on today’s dynamics so much as yesterday’s. BoP data is even worse, only coming out quarterly. So, the suggestion late last year that the daily price gyrations of bitcoin might work as a high-frequency-hot-money proxy certainly raised eyebrows. The simultaneous weakening of the yuan and rapid rise of bitcoin (and cryptocurrencies more generally) between mid-2015 and May of this year sparked wide speculation about the relationship between the two. The apparent inverse correlation led observers to posit that as the PBOC tightened capital controls and the yuan continued to weaken, bitcoin became an increasingly attractive way for Chinese residents to get their money out of the country. An examination of daily bitcoin trading volumes provides prima facie evidence that this may have been the case between late 2015 and late 2016. However, any correlation between the price of yuan and the price of bitcoin collapsed early this year. Bitcoin continued to surge through the first half of 2017 despite a consistently strengthening yuan. This alone though is not proof that there was never any causation between the two. The coincident clamp down on cryptocurrencies by China (just as the correlation was breaking down), and subsequent rise in bitcoin trading outside of China show that the dynamics driving the price of bitcoin changed fundamentally in the first few months of 2017. In 2015 and 2016 the overwhelming majority of bitcoin trading was conducted through China-based exchanges and with yuan. According to data from Bitcoinity, over 90 percent of trading volumes throughout 2016 were in exchange for yuan.* And plotting the dollar price of bitcoin against the dollar price of CNY (or CNH) during this period is, at the very least, an intriguing exercise: (Source: Paul Mylchreest of ADMSI as cited in the FT ) The above graph takes some liberties with its use of truncated/separate axes and the fit is far from perfect (particularly the decline in the price of bitcoin that followed the big August 2015 devaluation). But the late 2015 and mid-2016 surges in bitcoin concurrent with opposite moves in the yuan-dollar exchange rate warrant some attention given the context of the PBOC closing other avenues for capital outflows. Graphing daily CNYBTC trading volumes against the dollar-yuan exchange rate pretty clearly shows that, during the period in question (late 2015 through February of this year), CNYBTC trading spiked in the days following yuan weakness. So, it seems conceivable that the roughly 250 percent rise in the dollar price of bitcoin between January of 2015 and January of 2017 was due at least in part to Chinese capital outflows. However, any causation between the two was very much one-sided. Bitcoin may have been a proxy for downward pressure on the yuan, but bitcoin outflows likely only ever made up a small amount of Chinese capital outflows. Bitcoin trading volumes were fairly large in late 2016 and early 2017, but they're now trivial compared to, say, USDCNY trading volumes. Is it fair to compare bitcoin trading volumes to the 6th most traded currency pair in the world? Not really, unless you’re trying to make the point that there’s no endogeneity problem when it comes to bitcoin and the yuan. But any relationship that may or may not have existed between the price of bitcoin and the yuan is very much a thing of the past. In January of 2017 the PBOC publically announced they had met with the three largest China-based bitcoin exchanges in order to “remind them to ‘strictly’ follow relevant regulations on risk control and to ‘clean up’ any irregular practices” (FT article). This announcement was followed by increased scrutiny of the exchanges and rumors of coming cryptocurrency regulations. In early February, the two largest Chinese bitcoin exchanges, OKCoin and Huobi.com, halted bitcoin withdrawals. The price of bitcoin fell on the news, but the larger and more lasting effect was a huge decline in the share of bitcoin trading done in China or in exchange for yuan. In January, 96 percent of bitcoin trading volume was in exchange for yuan, in February the yuan share of bitcoin trading fell to 25 percent, then a paltry 14 percent in March. The vacuum left by the PBOC’s crackdown was partially filled by trading in other currencies (mostly USD), and the price of bitcoin more than recovered. Which is all to say that bitcoin is no longer a China story, and hasn’t been since early this year. The yuan’s swift appreciation beginning in late May of this year laid this fact very bare. The “Chinese-outflows-are-driving-the-price-of-bitcoin” narrative would predict that sustained appreciation in the yuan would depress the price of bitcoin as more Chinese would be willing to hold on to their yuan. Instead bitcoin soared: gaining some 90 percent over the same period that the yuan appreciated almost 6 percent against the dollar. And while bitcoin tumbled earlier this month on reports that China was shutting down exchanges, its rapid rebound, despite confirmation of those reports, seems to point to investors’ recognition that China is no longer as central to bitcoin’s expansion. *The bitcoin trading volume data presented here covers any trading that occurs over an exchange, but excludes over-the-counter (OTC) bitcoin trading. OTC trading—reportedly a preferred method for large transactions—is peer-to-peer and, by its nature, difficult to track. China's recent efforts to curb bitcoin trading were aimed both at the commercial exchanges and some of the popular platforms used for OTC trading. [Edit: Due to a spreadsheet error some of the graphs in the original post understated the magnitude of bitcoin trading volumes. They have been updated and the post has been edited to reflect these changes.]

Most countries intervene to limit appreciation, not directly to depreciate their currency. And limiting appreciation is a problem when the country has a large external surplus.

The Trump Administration seems to think of currency manipulation primarily as an issue with China. But “currency” actually is a much broader issue. Korea, Taiwan, and Singapore all have bigger current account surpluses, relative to their GDP, than China does. All have intervened to limit the appreciation of their currency within the past year. And all three have a long history of intervention, even if they intervened somewhat less when the dollar was exceptionally strong between the middle of 2014 and the middle of 2017. But the country that comes closest to meeting all three of the numerical criteria the Treasury now uses, following the Bennet amendment, to determine whether or not a country qualifies for “enhanced bilateral engagement” (what used to be called manipulation) is Thailand. Yep, Thailand. The three criteria are: Intervention (purchases, I assume) in the foreign exchange market in excess of two percent of GDP. A current account surplus in excess of 3 percent of GDP. A bilateral goods surplus with the U.S. of more than $20 billion dollars.* Thailand easily meets the first two criteria. Its current account surplus has soared after the baht’s depreciation in 2015, and now is close to 10 percent of Thailand’s GDP. 10 percent of GDP is a big number—it is higher than Germany or Korea right now. And roughly equal to China’s pre-crisis surplus at its peak. Thailand’s intervention in the foreign exchange market—including its intervention in the forward market—topped five percent of its GDP in the last twelve months of balance of payments data. Thailand’s reserves rose strongly in July and August, so there is no doubt Thailand continued to intervene throughout the third quarter. So it all comes down to the third criteria: a bilateral goods surplus with the U.S. in excess of $20 billion. And Thailand comes close. Very close. Its bilateral goods surplus in the last four quarters of U.S. data is above $19 billion… Changing the criteria to include services wouldn’t let Thailand off the hook. In 2015 Thailand ran a small bilateral services surplus with the U.S. (see table 2.2 or table 2.3 in the services trade data interactive tables; 2016 data isn’t yet available, the services data comes with a long lag and the bilateral data isn’t especially reliable). Remember the U.S. services surplus is mostly tourism—not anything more highfalutin (most services are still hard to deliver across borders and across time zones, and, well, our IPR giants tend to understate their intellectual property exports for tax reasons). And Thailand is also strong in tourism: the United States (like China) runs a bilateral tourism deficit with Thailand. Thailand historically hasn’t been covered in any detail in the foreign exchange report. It isn’t on the monitoring list in the last foreign exchange report. It hasn’t been “put on notice” so to speak. It should be. Based on current trends, Thailand’s bilateral surplus is likely to exceed the $20 billion threshold soon. Of course, there is an elephant in the room: Thailand’s 1997 crisis, and Thailand’s belief that the U.S. didn’t provide it with as much assistance back then as say it provided to Mexico.** But a crisis in the 1990s shouldn’t be a free pass twenty years later. Neither Thailand nor for that matter Korea should get “a get out of jail free” card now because of events twenty years ago. Thailand got into trouble in 1997 for a host of reasons: a credit-fueled real estate boom produced a large current account deficit, a lot of real estate companies took out a lot of foreign currency denominated debt even though they lacked foreign currency revenues, and the Thai banks and finance companies funded their domestic foreign currency lending with risky short-term borrowing. But it also fundamentally lacked enough reserves back then. Overall reserves weren’t high absolutely, and it turns out that Thailand had sold off a large fraction of its reserves in the forward market trying to defend the baht, so it really had almost zero in the bank. At the end of the second quarter of 1997, Thailand had about $30 billion in headline reserves, and had sold almost $30 billion forward. It literally had nothing in the bank. Thailand’s reserves, though, are way bigger now—absolutely, and relative to short-term external debt. Thailand has $180 billion plus in reserves, and has bought $30 billion in the forward market—so its reserves are higher than the headline number. Total reserves, counting forwards are about 50 percent of Thailand’s GDP—and its short-term debt is only a bit over 10 percent of its GDP. So while Thailand absolutely needed to rebuild its reserves and bring down its debt after its 1997 crisis, it subsequently has gone overboard—and is pretty clearly now intervening to hold its currency down, not because it needs more reserves to protect itself from another crisis. A current account surplus of 10 percent of GDP and reserves of close to 50 percent of GDP makes Thailand a small-scale version, numerically, of China back in 2007 or so.*** And, well, Thailand’s intervention does have an impact on the U.S. economy. Thailand is a big producer of auto parts and other manufactures these days, it isn’t primarily a commodity exporter.**** Perhaps some of the over $3 billion in imports of telecommunications equipment, the $3 billion in imports of auto parts (including tires) from Thailand and $0.75 billion in imports of household appliances just squeezes out other imports—but competition from places like Thailand also adds pressure on other countries to keep their exchange rates artificially depressed. It all adds up. One last point: designating a country for “enhanced bilateral engagement” doesn’t lead automatically to meaningful sanctions, let alone a trade war. The sanctions outlined in the Bennet amendment are quite mild. But it would force a dialogue. And, well, if the Bennet sanctions are too mild for the Trump Administration’s taste, they could always experiment with counter-intervention.   * I am not a huge fan of the bilateral balance criteria. For one, I think it lets the NIEs (Hong Kong, South Korea, Singapore, and Taiwan) off the hook a bit too easily, as they export parts to China and thus account for a portion of China’s surplus! But more generally, there is no particular reason to think a bilateral surplus with the U.S. on its own signals an unhealthy overall pattern of trade. But in Thailand’s current case, its bilateral surplus with the U.S. is a component of its overall surplus, and the overall surplus is clearly quite large. ** Thailand did not get a bilateral credit line from the Treasury’s Exchange Stabilization Fund back in 1997, in part because of the restrictions that Congress placed on its use after Mexico. But I think the reality is that the use of the Exchange Stabilization Fund is the exception not the rule–Mexico was treated a bit differently because it is on the U.S. border, but also because it really did primarily have a short-term liquidity problem and thus was in a position to repay the Treasury quite rapidly. *** The combined current account surplus of the NIEs, Malaysia, and Thailand in 2016 was around $300 billion– substantially larger than China’s $200 billion surplus in 2016. Malaysia is the only one of these six that hasn’t been intervening this year to limit appreciation. **** Thailand’s commodity exports are actually down a bit: the U.S. is importing less Thai seafood these days, and the U.S. is no longer importing oil from Thailand (a few years back the U.S. was importing half a billion in oil from Thailand–there are often surprises hidden in the bilateral numbers).

For the past fifteen or more years, if not longer, the flow of foreign exchange in and out of China has never quite seemed to balance. Either the yuan was a one way bet up, and the PBOC had to buy foreign exchange to keep the currency from appreciating, or the yuan was (thought) to be a one way bet down, and the PBOC had to sell a lot of foreign currency to keep the yuan from depreciating. Neither was an especially comfortable position for the central bank. In August, though—and frankly through most of the summer—the available evidence suggests that inflows and outflows almost perfectly matched.* The stock of foreign exchange reserves reported on the PBOC’s yuan balance sheet—which shows its stock of foreign exchange reserves at its historical purchase price—didn’t move. And the numbers on foreign exchange settlement, which technically shows the flow of foreign exchange through the banking system but in practice tends to be dominated by the PBOC, show very modest net sales if you don’t adjust for reported forwards, and small net purchases if you do. It is pretty amazing if you think about it. The PBOC supposedly thought flows were close to balance when it reformed its foreign exchange regime way back in August of 2015, but quickly discovered that the apparent balance hinged on expectations that the PBOC would keep the exchange rate constant. Those expectations, obviously, were disrupted by the August 2015 depreciation. Two years and a trillion or so in reserves later,** and calm has been restored. To the chagrin of those who bet that the August 2015 depreciation augured a big future move down: some thought the depreciation signaled that China’s leaders wanted a much weaker currency (and I suspect China’s leaders did want a somewhat weaker currency; the yuan did depreciate against the CFETS basket from mid 2015 to mid-2016), others thought that the depreciation signaled that the PBOC was about to lose control over the exchange rate (not a view I shared). Yet it seems that the August equilibrium was itself somewhat fragile. The yuan shot up in the first week of September. I suspect—without having hard evidence—that the PBOC had to intervene to keep it from rising more. And then the PBOC loosened some of the controls that it had put in place to limit depreciation pressures. That was—rightly I think—interpreted as sign that China’s government didn’t want the currency to appreciate too much. The investment banks all seem to think that China’s exporters started to think the yuan was a one way bet up and started to unload the dollars they had accumulated back in 2016. Three more comments: 1) The PBOC could have used the reemergence of appreciation pressure to rebuild reserves, rather than to loosen controls. The fact that it didn’t suggests something about the PBOC’s policy goals. Among other things, it suggest the PBOC doesn’t think it needs more than $3 trillion in reserves. I agree. The three trillion number came from the heavy weight the IMF’s new reserve metric placed on local currency deposits if a country has a fixed exchange rate and an open capital account. The IMF’s China team, incidentally, also now recognizes—see paragraph 44 of its latest staff report—that the reserve metric doesn’t really fit China.*** 2) John Authers of the Financial Times noted last Friday that in China “the market and the economy are state-controlled.”**** That’s still largely the case for the onshore foreign exchange market, even if there are some channels that are difficult for China to completely control. China has lots of tools—especially now that it reversed the August 2015 reforms and effectively reintroduced the “fix” as a market signal back in June. It can dial capital controls up or down. And I think it can also dial the amount of state bank lending—and borrowing—from the rest of the world up and down. One reason why flows stabilized after the first quarter is that Chinese banks seem to have slowed their breakneck foreign loan growth (they also started borrowing more from the world, so their net foreign asset position stopped growing and actually looks to have shrunk a bit—but that’s a very technical topic for another time). In other words, balance in the market has come in part through managing the flows allowed to enter the foreign exchange market. I don’t really expect that to change—any coming liberalization is likely to be done in ways that are reversible.***** 3/ Exchange rate moves impact trade flows with a lag. The August appreciation of the yuan almost certainly had no impact on China’s August trade data (year-over-year volume growth was down a bit in August relative to July, but that is likely a result of standard volatility in the trade data—and the fact that the base from August 2016 was quite strong). A good rule of thumb is to look back a year to get a sense of the impulse the exchange rate is giving to current trade flows. And by that measure, China is still getting a boost from the exchange rate. Plus, well, the yuan—against the dollar—really isn’t that far from where it was eight or nine years ago and ongoing productivity gains should be leading the yuan to appreciate over time. And even with the yuan’s appreciation in August and September, the broad yuan is down close to 10 percent from its peak (against the CFETS basket)—though to be fair, that depreciation came after a significant appreciation in late 2014. I am not particularly impressed by the recent whinging of Chinese exporters (who probably should have hedged their future export orders earlier in the year but, well, probably didn’t when they expected the yuan to continue to depreciate). Chinese export growth in the first half of 2017 exceeded global trade growth, and exports to the U.S. have been doing just fine this year.     * There was a brief period in the summer and fall of 2012 when the PBOC doesn’t seem to have intervened much, as the euro crisis spilled over and triggered an emerging market sell-off. The foreign exchange reserves reported on the PBOC's balance sheet (in yuan terms) were also relatively flat for a period in late 2014 (when the dollar was appreciating), though the settlement data suggests sales in September and q4. ** About half of the fall in reserves is balanced by a fall in short-term debt. And a significant fraction of the remaining half a trillion is explained, in a mechanical sense, by the ongoing rise in the foreign assets of the state banks. *** I think it also doesn’t work that well for a lot of under-reserved emerging economies—largely because it gives equal weight to domestic and foreign currency deposits. **** “The market and economy are state-controlled (even if the profit motive is put to much more use than it was in previous communist experiments)”; I enjoyed the entire column, though I also tend to think that the eventual credit “reckoning” could still play out with some very Chinese characteristics (e.g. through a rather opaque recapitalization similar to what happened after 2003, though made more difficult by a slower underlying pace of growth). ***** I am not sure that is a bad thing by the way. I agree with Martin Wolf’s argument that it safer for everyone if China’s domestic financial system is kept one step removed from global markets so long as the domestic financial system has so many undercapitalized institutions (backed by an implicit or explicit state guarantee).

Korea's macroeconomic policies have had a greater impact on its pattern of trade than any free trade agreement.

Keep an eye on the return of Asian intervention

G-3 exchange rate moves over the past four years have had expected impacts on trade flows

The world would be in a better place today if the ECB and BoJ had joined the Fed in quantitative easing early on. Their lag in easing contributed to the policy gap that led to the dollar's large 2014 appreciation.

No sign of pressure on China's exchange rate regime in the June intervention proxies. Overall intervention in the second quarter is back at pre-August 2015 levels.