Does China’s 2.5 Percent Inflation Rate Really Explain The Decline In The Value Of Its Currency Against The Dollar?

In an article on the decline in the Chinese yuan against the dollar the NYT gave as one explanation:

“Inflation has begun to tick upward, and rising prices tend to make holding the relevant currency less attractive.”

That one really doesn’t seem plausible to me. In the most recent data, China’s year over year inflation rate was 2.5 percent, virtually identical to the U.S. rate. If we look to 2019, the I.M.F. actually projects China’s inflation rate will fall slightly to 2.3 percent, a hair lower than the rate projected for the U.S.

In assessing whether China is holding down the value of its currency it is important to note that the country holds more than $4 trillion in foreign reserves through its central bank and sovereign wealth fund. This holds down the value of its currency compared to a more normal level of holdings for a country with an economy the size of China, which would likely be in the range of $1-$2 trillion.

This is the same logic as the belief that the Fed is holding down U.S. interest rates by virtue of the fact that it holds $4 trillion in assets as a result of its quantitative easing policy. A more normal level would be around $1 trillion.

The vast majority of economists believe that the Fed’s asset holdings keep down U.S. interest rates. It is inconsistent to believe that the Fed’s holdings of U.S. assets keep down interest rates here, but China’s holding of foreign assets does not keep down the value of its currency.