In June of 2015 as Chinese stocks crashed, the Chinese central bank, the People’s Bank of China (PBOC), wrote to the United States Federal Reserve to ask for their advice in mitigating a stock market plunge. (Reuters) The specific advice related to how Greenspan dealt with Black Monday in 1987 including how to inject cash into the market and also provide reassuring messages to the market. China, however, was facing three challenges: it had to maintain a currency peg, support equities and target interest rates on the open market. Two months later the PBOC chose to drastically devalue their currency.
The United States and China differ in the policy options available to their Central Banks for two main reasons. First, the United States is restricted in how much it can devalue its own currency without causing global turmoil. Secondly, the United States Federal Reserve is limited in its trading ability by the Federal Reserve Act. Their actions, however, are similar to the PBOC but require different avenues to remain legal.
The Fed and PBOC are also alike in that they require their currency to be stable. The United States benefits from the Dollar being the primary reserve currency, a position which requires a stable currency at least relative to other major currencies. Likewise, China, who wishes the Renminbi to become a major reserve currency, cannot manipulate their currency openly. Therefore, both are constrained in this aspect. However, in a globalized world of free-floating exchange rates, many policy options remain available.
The President of the New York branch of the Federal Reserve, Bill Dudley, has noted that despite the vast capital provided to banks during the recession, including their large excess reserves, and the increasingly large balance sheet at the Fed, little inflation has been seen. In other words, despite a huge injection of cash into the market, inflation remains invisible. Short term this can be accomplished in two ways: pegs to other currencies which must be maintained by balance sheet purchasing or selling, and manipulation of the futures markets especially currency and commodity futures. The PBOC prefers the former method and the Fed prefers the latter method. (NYFED)
Currency pegs have the downside of being highly visible and expensive to maintain over the long run. China, for instance, could not maintain their peg to the Dollar; nor could Switzerland maintain its peg to the Euro. The Chinese originally started in 1994 with a floating peg to the Dollar. This peg was maintained until 2008 when the float became a managed float still tied to the Dollar. Finally, in 2015 the Chinese received reserve currency status from the IMF and removed any explicit pegs. Now, after a huge currency devaluation in August of 2015, trading data seems to show a peg to gold. Regardless, pegs seem to be used by the PBOC to maintain stability.
In the United States, the Federal Reserve has a dual mandate to minimize unemployment and keep inflation low. This mandate means that the Federal Reserve cannot base monetary policy on pegs. Even though a peg to gold was historically used by the Fed, it was abandoned in the 1970s precisely because of its inflexibility. Since then, the Federal Reserve has been more reactionary to economic indicators and focused on keeping an inflation peg at 2%. This floating currency management makes transparency and communication between the Fed and the market very important.
Both pegs to other currencies and pegs to inflation require constant active trading to maintain the peg. Thus, the PBOC and Federal Reserve have active trading bodies to maintain a balance sheet for the central bank. Though the balance sheets of the PBOC and Fed are not entirely known, the composition varies extensively. This difference is partially due to the different mandates, but also because of the sophistication and institutional knowledge at each bank. The Fed has been in the stability business much longer and has developed extensive internal trading methods and partnerships. We will focus on the different methods used by the Fed and PBOC for manipulating currency supply and currency valuation through the market.
The PBOC has traditionally managed its currency value by holding the largest foreign currency balance sheet of any central bank. (Bloomberg) This vast stockpile of foreign currency could be sold or bought to establish other currencies’ value relative to the Chinese currency. In addition, buying and selling had the dual purpose of affecting both the other currency and the money supply in China. However, the trading operations performed were rather transparent and often met resistance by hedge funds which used the trading signals to bet against the Chinese currency. To counter these speculators, which China blames for its most recent currency crisis, the Chinses government has at times halted currency trading by foreign banks and proposed taxing currency trades. (People’s Daily)
However, over the past decade the Chinese have also been building a more sophisticated trading arm. For instance, since 2009 the PBOC has inked 31 currency swap agreements that provide currency liquidity to other central banks through reverse repo sales. (Zerohedge) The reverse repo instruments are offered at an overnight rate much like the federal funds rate. By varying this rate offered to other central banks, the PBOC has a window into a currency market previously only offered by the Federal Reserve. (Zerohedge)
In contrast, the Federal Reserve has been developing currency liquidity agreements, swap agreements, and currency settlement agreements with countries and central banks ever since the Bretton-Woods currency regime broke down. For this reason, the Chinese knew where to go for advice when their currency became strained in July of 2015: the Federal Reserve. (Zerohedge) (Reuters) That said, the institutional knowledge at the PBOC is only beginning to catch up to that of the Federal Reserve. For instance, the Federal Reserve has avoided using direct currency interventions which must be reported to the treasury. (Bloomberg) Instead, the Federal Reserve prefers currency swaps, reverse repos, and short positions on commodities to effect its monetary policy beyond the nation’s borders. (CFR)
Thus, the central banks of China and the United States were much different only a decade ago, but are increasingly playing the same game with almost as sophisticated tools. An adoption of the Chinese system would give our Federal Reserve more power to intervene in equity markets during a recession. However, if one has a Schumpeterian view of the economy, support of weak firms through direct equity purchases may be counter-productive. Therefore, given the sophisticated tools available to the Federal Reserve which barely fall within the limitations of the law, more change would likely occur if/when the Chinese adopt the trading methods of the Federal Reserve.
“Currency Intervention” https://www.newyorkfed.org/aboutthefed/fedpoint/fed44.html
Lang, Jason. “China central bank to Fed: A little help, please?” Reuters. 21 March 2016
People’s Daily “A declaration of war to the Chinese currency? ‘Ha ha’” 26 January 2016.