Currency Values: What the Christ?

In the comment section of my last post, Dave asked me to clarify a few things about how imports affect currency values. Having given it some thought, I now realize that not everyone reading this blog has spent the past few years of their lives learning about the virtuous optimality of a Dickensian distribution of income (i.e. study economics) or happen to suffer from that particular form of brain worm that leads a person to voluntarily immerse oneself in economic literature (Lion). Therefore, I'd like to take this opportunity to explain for those who are interested that whole deal with currency values. If my explanation resorts to asinine metaphor or a patronizing tone of voice, it isn't because I think anyone here is an idiot. Those who study economics are lucky enough to be a part of discipline which straddles the line between the byzantine abstraction of most academic fields and actual, real-life relevance. That is, economists get to be confusing on the news, not just in the lecture hall. I'm sure if there was a global crisis of post-modern literature, I'd be scratching my head along with everyone else.
So here we go: Exchange Rates. I apologize beforehand if this is all really boring.
Studying it myself, I find it much easier to wrap my head around exchange rates by thinking of currency as if it were any other commodity. The price of this particular commodity happens to be its exchange rate (that is, how valuable it is relative to all other currencies), and that price is determined by those ever-present crossing-swords, supply and demand.
When I talk about the "demand" and "supply" for a currency, I am talking about a few things:

a) Trade of Goods and Services: To give a tremendously oversimplified example, if I wanted to buy a Mexican-made radio, I, as an American, would be purchasing a radio imported from Mexico just as the manufacturer in Mexico is exporting that radio to the United States. When Mexico exports that radio, demand for the peso goes up. Why? I spend the money and somewhere along the supply line that money is converted into pesos. Within the foreign exchange market (not any one place, but an aggregate of thousands of different banks and financial institutions carrying out similar transactions for all trade between the U.S. and Mexico), this constitutes one additional "pull" on the Peso v.s. the American dollar; that is, one more person who wants X amount of Mexican pesos rather than the proportionate amount of Dolla-Dolla-Bills. If Mexican exports are suddenly all the rage and there are millions of stupid Americans like me buying cheap Mexican stuff, looking at trade as a factor alone, that demand for Mexican goods (and therefore pesos) will increase the "price" or "value" of the peso--the peso will "appreciate," so that it takes more American currency to buy the same amount of Mexican currency.
Likewise, during the same process, all the importation of Mexican goods to the United States increases the supply of American dollars on the foreign exchange market. This enormous supply, under these simplified conditions, should lead to a decline in the "price" of American dollars--the American dollar will "depreciate."

b) Financial Activity: to assume that exchange rates are determined simply by the trade of actual goods is to overlook the enormous amount of currency trading that goes on in financial markets. Some estimate that 90% of currency flows result from capital market activity. This kind of activity is often speculative and generally extremely complicated, but it suffices to say that if someone in America wants to invest in Mexico (either in stocks, bonds, etc, which is called portfolio investment) or in physical goods (such as a factory or a hotel or a housing development, which is called foreign direct investment), again, he or she has to exchange American dollars for pesos. This, all other things held constant, will increase the demand for pesos and the supply for American dollars respectively, and will contribute to a relative deprecation of the American dollar against the Peso.
Bringing it all back to the China-America issue one last time:
When I wrote that one blogger was speculating that the drop off in exports would put downward pressure on the Chinese yuan, I said this because of "factor a" above. If the United States and Japan and Germany and everyone else is in a recession and can't by Chinese stuff, the demand for the Chinese RMB falls as well.
What is the significance of this? China's exchange value is not determined by the foreign exchange market. Because a lower exchange rate (for a while around 8 Yuan for every 1 American dollar, now closer to 7:1) means that Chinese goods in America are cheaper, China has for some time actively kept its exchange value low to facilitate that lop-sided trade relationship. While this certainly complicates matters if someone in China wants to buy anything not from China, such a policy is unquestionably good for those Chinese firms in the business of manufacturing. So how do the Chinese keep their currency low?
Turning to "factor b" above, the Chinese government buys (partially with the money they recieve for all their exports) American (and European) financial assets. These purchases have largely been of U.S. government bonds (basically interest-bearing IOUs from the Federal Government), but also bonds of government sponsored enterprises (Fannie Mae, etc) and the commercial paper and equity of private firms. Regardless of where the money is going, the effect is the same: by buying up American financial assets, they are increasing the demand for American dollars, while flooding the market with Chinese yuan. Tinkering in the market this way, they are able to set a "peg" on their currency; a value or band of values from which the currency is not allowed to deviate.
A drop in exports however, which would decrease the upward pressure on the Chinese currency--so wrote the blogger--would mean that the Chinese government would no longer be so hard-pressed to buy up American financial assets. The consequences of such a shift, he wrote, could be serious for the American economy, since its all that financial activity--namely the buying up of American Treasury Bills (T-Bills being, once again, IOUs to the Federal Government)--that allows the Federal government to borrow so much so cheaply. As soon as the Chinese recognize that it is no longer in their interest to lend to (buy bonds from) the Americans, the Americans either have to stop borrowing or start offering a higher interest rate. The ramifications of this are manifold and mani-fucked, but I won't get into it too much.
What I was writing, on the other hand, was based on a BBC article which pointed out that while Chinese exports are indeed dropping, their imports are dropping further. Why? Countries buy imports when the people and the firms there have money to spend. Since the Chinese economy is so heavily reliant on exports, a decline in exports leads to a decline in consumer and business expenditures, which leads to a drop in imports. The significance of this for currency values--what Dave was asking about in a comment from a post below--is that if a decline in exports leads to a decline in demand for Chinese currency, a decline in Chinese imports also leads to a decline in demand for the currencies of China's import partners relative to the RMB. The net effect, with some oversimplification, is potentially zilch. The depreciative pressure resulting from a decline in demand for Chinese exports/RMB is countered (perhaps overwhelmed, given that the net exports of China during December were at record high levels) by the decline in supply of RMB in foreign exchange (forex) markets resulting for a decline in imports into China.
I hope I've made some sense of all this for those of you who couldn't make sense of my previous article. Exchange rate determination is probably one of the more complex processes in the world of trade and finance, so I've undoubtedly left out of a few factors. I just wanted to explain the basics so that, in the future, if I or anyone else talks about why it is that the American dollar is so strong right now (for instance), everyone will know more-or-less what the hell is going on.

Beating a Dead Tibetan 2: the Remetaphorizing!

Sorry to sweat-shop-belabor this--I'm sure we're all sick of discussing just where China falls on the Economic Boogy-man Index (76 as of yesterday)--but just to go back to point I was talking about earlier...
I mentioned an article/blog I read a few days ago which claimed that the current demand for treasury bills from China will likely begin to wane as their exports drop off. As demand falls for Chinese goods (and therefore Chinese RMB), so the argument goes, there is less upward pressure on the Chinese currency and therefore less need for the Chinese government to intervene directly into American financial markets to keep the peg...well, pegged. In his own words:

China no longer needs to be as active to keep the yuan (which now appears to be back to a hard peg) where China wants it to be. A presumably smaller current account surplus and a capital exodus would seem to be prime suspects. (Link)

Tonight, the BBC is running a headline: "China's Exports in Record Decline".
Bad news for China certainly, but not necessarily a vindication of the argument above. Scroll down on the BBC article and you will eventually find that

December imports fell even more sharply, declining 21.3%, the China Daily reported.

That was a bigger decline than November's 17.9% drop.

With exports in December worth $111.2 billion, and imports worth $72.2 billion, that made December's trade surplus $39 billion.
That is the country's second highest trade surplus ever, just short of November's record $40.1 billion. (Link)

Quothe Captain Obvious: China's economic growth has largely been driven by exports. Imports, otherwise considered exogenous (i.e. not at all related) to exports, are a function of overall demand within the economy. But for China, where overall demand is disproportionally accounted for by foreign demand through exports, a drop off in exports will necessarily lead perhaps not an equal, but proportionate decline in imports. This isn't just an issue of exports => aggregate demand => imports (if you'd like additional sophisticated diagrams, I'm available for any class or business presentations). Most of Chinese exports are "re-exports": raw materials are imported and assembled cheaply for export or sophisticated technological equipment is imported and, again, assembled cheaply for export. Therefore, imports aren't just a function of exports in an indirect sense (see elaborate illustration above), but literally make up the exports. As an aside, contrast this with the United States. If everyone were to hypothetically stop buying American stuff (see: past 10-35 years), that wouldn't stop all us good ol' boys and gals from buying everyone else's stuff because our economy is more "dynamic": the Camerro that is American economic progress also runs on domestic consumption, investment, government spending and, more recently, the tears of unicorns imprissoned in the sea by Alan Greenspan.
Back to China, as the article points out, in December the fall in imports was even larger than that of exports. I don't know if that is accounted for by an actual decline in quantity imported vs. exported or by a change in currency values between one of China trading partners. Whatever the case and whether that will continue to be the trend (or whether there will be a trend at all) is secondary to the point that, because China's very economic soul predisposes it such that a drop off in exports will entail some degree of declining imports, at least in the short-term, the global recession will not fundamentally alleviate the upward pressure on that country's currency.
I should point out however that currency values are not solely (and in many cases primarily) determined by current account fluctuations (exports and imports), but by capital markets.
And everyone knows how predictable capital markets are.