How does China Manipulate its Currency?

by Manshu on January 26, 2009

in Articles

China’s currency manipulation remarks by Mr. Tim Geithner hit the front pages of all major newspapers last week. So let’s take a look at how China manipulates it currency.

To be fair to China, almost every country in the world manipulates its currency. In an ideal free market world – there would be no government intervention in the currency markets. However, there is hardly any Central Bank in the world that doesn’t intervene, when its currency starts to appreciate or depreciate beyond a certain price band.

Almost every Central Bank has a certain price band for its currency in its mind, and as soon as the currency goes beyond that band, governments start intervening in one way or the other.

This government intervention can be direct or indirect.

Buying Dollars to Keep the Dollar Price High

China has been interested in keeping the Yuan (Chinese Currency) undervalued relative to the US Dollar, and the easiest way (if you can afford it) to keep the Dollar price high, and the Yuan low is to buy dollars from the open market.

A country like China, which runs a huge Trade Surplus can afford to buy dollars in the open market to keep the demand for dollars high, and push the dollar price upwards relative to the Yuan. This keeps the Yuan undervalued.

Indirect Measures

There can be indirect interventions like putting a cap on the amount of foreign assets that locals can invest abroad. For example – India allows its residents to invest only up to $50,000 in foreign assets every year.

Other indirect measures can relate to taxation laws. For example – by allowing tax free repatriation of the Great Britain Pound – the British government can help boost inflow of Pounds in the country, and influence the exchange rate.

Why Does China Wish to Undervalue the Yuan?

China’s engine of growth is exports. The lower the value of the Yuan, the better it is for China’s exporters. Basically, if 1 Dollar buys 7 Yuans, and a exporter sells a Chinese Shirt for 10 dollars – he pockets 70 yuans. But if one Dollar was worth only 5 Yuans, the exporter would only be able to pocket 50 yuans.

By How Much is the Yuan Undervalued?

It is really impossible to tell by how much the Yuan has been undervalued, but estimates suggest that this range is between 15% – 40%.

A direct consequence of keeping the local currency undervalued is inflation, and since China faced rather high inflation rates in 2008 – it did plan to let its currency appreciate in 2008 (but that was before sub-prime).

How is the US Impacted?

It can be argued that the US is flooded with cheap imports from China not because China is really cost – competitive, but because China has artificially kept its currency undervalued. If the Yuan was allowed to appreciate – Chinese imports may no longer be cheap enough to compete with American produced goods.

On the other hand, it could really be that the Chinese are cost competitive, and it is really cheaper to produce goods in China than it is to produce them in US.

The truth probably lies somewhere in the middle.

US Stimulus Spending

The US runs huge trade deficits, and has plans for massive stimulus spending. The deficits mean that this stimulus spending can be done by either issuing more debt to foreign countries or printing more dollars.

If Mr. Geithner’s comments continue; they may aggravate China to such an extent that it stops showing up at the Treasury Bond auctions.

If that happens, then the US will have to resort to printing currency and quantitative easing on a scale that unleashes massive inflation.

It will be interesting to see how the situation unfolds, and how Mr. Geithner deals with China’s “Manipulation” – if and when he actually takes office.

Update: Tried to get rid of the “irritating” hyphens.

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{ 29 comments… read them below or add one }

Kim Woodbridge January 26, 2009 at 8:47 am

Hi – Thanks for this article. I didn’t know anything about this – China purposefully keeping the yuan undervalued – it’s very interesting. And as an American, a little frightening.

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manshuv January 27, 2009 at 5:03 pm

Kim, I guess it is more of a pre-emptive tactic by the Obama administration.

The Chinese might be tempted to depreciate their currency again, and export out of this recession. And the current administration wants to nip it in the bud.

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Biplab Das January 29, 2009 at 3:11 am

I read about this in Lee Iacocca auto biography also. This has been going on for say last 60 years. How they (chinese central bank) are able to manage it?

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Manshu January 29, 2009 at 2:23 pm

Well, Biplab, I guess it can’t be that hard to buy dollars when you make everything in the world!

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Hank February 12, 2009 at 3:39 pm

Great post! You really laid it all out there for us. Thanks!

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Manshu February 12, 2009 at 4:16 pm

Thanks Hank, it will be interesting to see how this plays out.

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Alex January 10, 2010 at 3:28 pm

I always thought the Chinese government buys and sell the Chinese currency (Yuen) to control its currency, and no doubt, I was wrong.

Thank you for clarify this for me :)

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Kunal January 16, 2010 at 7:51 pm

Thanks for explaining it in a simple and lucid manner. No matter how much I read about currencies and foreign markets I find it difficult to understand. Is there any book you guys referred to when studying MBA finance which makes it easier to understand ?

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Alexx February 18, 2010 at 7:15 am

Hi,

Thanks for the article! It was very enlightening. Your misuse of hyphens was rather irritating, though. A hyphen should only be used – for example, like this – when the bit inside the hyphens can be removed completely from the sentence without removing the meaning of the sentence. And it should never be placed randomly in the middle of a sentence.

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Anon September 19, 2010 at 7:40 pm

Hello Alexx (and author),

What you’re talking about is a dash (–), which can be used singly, in a similar way to a colon, or in pairs, as you described. A hyphen (-) is much smaller and is used to connect two or more words to clarify meaning. An example is forty-year-olds (people who are forty) and forty year-olds (forty one-year-old children).

Anon

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Anon2 September 20, 2012 at 4:07 am

What Alexx is actually complaining about is the apparent substitution of commas (,) in a sentence with dashes (–) where they should not be.

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beth February 28, 2010 at 7:09 pm

Thanx,
I have a test in ecp geo monday n my profeesor is like Buller’s. Anyone anyone…. thanx again, makes sense now. very organized

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Alternative Energy Supply June 27, 2010 at 9:24 pm

Makes perfect sense. However, I don’t see them being undervalued as an advantage. It means that their money is worth less. They have less buying power. In the short run, yes, an exchange rate change means they lose that 20 Yuans. But in reality, they should be raising their prices as their currency gains power. So they will make the same money, but we will have to pay more for it. That’s the problem with having less power in currency. When China buys from us, they are paying a lot of money for goods. When we buy from them, we get a killer deal. To me, the Chinese are the ones who are losing out by keeping their currency so low.

I guess what matters is what you’re trying to do. They just want to keep their exports going, so they don’t mind making less. We want to stop from importing so much, so we want their rate to go up. But things are still cheaper when made there, so the exchange rate change isn’t going to solve our problem. It will eliminate some exports, but not the majority of them. The US still doesn’t manufacture a lot of things and we must source out of the country to get them. The good news is clothing might stop coming from China, which should be made here!

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Jacqueline September 15, 2010 at 1:34 am

To Alternative Energy Supply:

Well I have to disagree with you. I think it makes perfect sense and is a great advantage to China too. It is true that with an undervalued currency, Chinese’s spending power is weaken. However, this would encourage them to purchase local goods instead and at the same time discourage imports. This would not be difficult seeing that they are making almost everything in the world. Hence it ensures that China can maintain a Trade Surplus and support their ever expanding manufacturing industry. Moreover, it makes China a more welcoming place for foreign investments, which helps to create jobs for the local.

Looking the issue from US, it is more expensive to buy local goods than China made goods. Given higher spending power, Americans would import more from China and hence this contributes to the high Trade Deficit. In addition, it discourages the local manufacturing industry to grow and many businesses would want to shift to China instead as it is definitely cheaper to produce goods there. This has a negative effect on America; jobs are lost, wages are cut etc.

So I don’t see how having an undervalued currency would not be an advantage to China.

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nishaanth May 27, 2011 at 3:31 am

excellent reply!!!

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terry July 2, 2010 at 8:35 am

But aren’t the Chinese using many of these dollars to purchase US debt?

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jay September 8, 2010 at 6:37 am

Great article, however I would disagree that the cheap currency is the reason for Americans losing their jobs.There have been hot debates on outsourcing and unemployment. Its simply corporate greed.

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Joe March 18, 2012 at 7:21 pm

As soon as someone throws out corporate greed you can rest assured they haven’t done their homework. What are you saying? That corporate greed has caused these businesses to look to keep their costs down BECAUSE they want to hurt American workers? Or is it possible that to compete they need to find ways to keep their costs down and therefore have things manufactured abroad? If I start a toy business and I expect to compete with Hasbro, for example, I have a couple of option: 1. Make toys here in the US at a much higher price than Hasbro and hope that I have something special that will compete with Hasbro (and spend hundreds of thousands of dollars to appease my gov’t while doing so), or 2: have my toys manufactured in China so I can compete on equal footing with Hasbro. One option is to take away the strangle hold the gov’t has on any industry in this country and they will lower prices a hell of a lot. That way the price difference may not be as extreme as it is now – jobs might just find there way back to the US (they are now anyway). To compete as a business you find any means necessary within the law to make your business more competitive to serve your customer. As a co-business owner I know this is the case. If we could offer our product at a substantially discounted rate from the other businesses we compete with we would do it. However, do you know why we can’t? Gov’t regulation – and lots of it!

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SS October 26, 2010 at 4:21 pm

The description on this page might apply to the situation decades ago, with the old Bretton Woods agreements. Today, China has a much simpler process for manipulating its currency. See James Fallows’ article in the January 2008 Atlantic Monthly.

We pump about a billion dollars into China each day, buying iPods and televisions. The Peoples’ Bank of China soaks up the dollars and exchanges them for yuan at whatever rate it wants. By law. No choice. No open market transactions. Period. Done.

At the end of each day, the Chinese government sends a billion dollars to America to buy bonds and government securities. That’s two items – one is currency manipulation which is done very simply. The other is our freakin’ huge trade deficit; all the policy implications around that; and its consequences.

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Tyron January 5, 2011 at 12:35 am

Milton friedman a famous authour argued’ There is only one social responsibility of business – to use its resources to and engage in acitivties desigined to increase it profits as long as it stays within the rules of the game….’ One must remember that the Chinese government have a religious commitment to their people in that actions are mainly to benifit their economy. The chinese are of a collectivist soceity,( US the opposite). Their government should be seen as extensions of all businesses in china, therefore the US should seek out ways of getting jobs, and better produce for its citizens rather than be concerned with the loyality the chinese government show to their people. AS the lay man would say ‘doh cry help ur side’. The US government needs to be more inovative and maybe stop pumping so much money in oil producing countries in principle the chinese have the same maniplulating tatics as the Obama’s administration.

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Sriram Kanniah January 18, 2011 at 2:30 pm

Very well said. I totally agree to what you have said. However, based on your below statement, i was thinking how the indirect intervention works technically..
> There can be indirect interventions like putting a cap on the amount of foreign assets that locals can invest abroad. For example – India allows its residents to invest only up to $50,000 in foreign assets every year.

For investing in the foreign assets, the local currency has to be exchanged for the $. By putting a cap on the foreign investments that a local can make, the government is actually restricting the buy of $.. If so, then there will be less demand for $ and that indirectly appreciates the local currency against the $. So, how such a restriction would indirectly help to undervalue the local currency.

Could you please clarify a little bit? Thanks again for the article!!

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Luis Alfonzo August 7, 2011 at 9:57 pm

It’s not that there is no demand for the dollar and that this would create a higher demand for the locla currency. When a currency control is placed and there is a limit to the amount of the local currency that can be changed into dollars you are preventing a significant increase of the amount of dollars to the local currency in the market due to currency exchange. This doesn’t mean there is no demand for the dollar just because a restriction has been placed, quiet the contrary. The restriction is placed and continued because the demand for the dollar is there. This prevents a value increase of the local currency to dollar, and if this local currency depends on exports like china, india, japan, singapore, south korea, etc you are making sure profit keeps at its highest level possible. Just ask Japan and Toyota about their struggle with controlling the yen.

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fred jiang February 21, 2011 at 10:43 am

By nominal exchange rate, Chinese Yuan may not appreciate much, but if you look at real exchange rate of Chinese Yuan, it is much higher, aprreciate about 50% since 2005. The main reason is the inflation of China is much higher than it’s nominal exchange rate. Of course China would like to keep the Yaun weaker to facilitate their export, but in reality, it is much better to US manufacture now than 5 years ago. Plus cost of labor went higher and cause Chinese manufacture much less competitive than before.

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kavitasyon February 23, 2011 at 3:05 am

This is what happens when you ram hundreds of pages of TARP legislation through Congress with scare tactics that if it’s not immediately passed there will be violence in the streets and economic armageddon will ensue.

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Jon April 11, 2011 at 8:04 am

Hi, great article, really informative and unbiased.
I don’t get this part though.

“There can be indirect interventions like putting a cap on the amount of foreign assets that locals can invest abroad. For example – India allows its residents to invest only up to $50,000 in foreign assets every year.”

Wouldn’t this push the Indian dollar up? Less Indian currency in the world market, means higher demand vs supply? Seems more like a mercantilist policy than one that has to do with currency control.

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Shellcore April 27, 2011 at 4:40 pm

Isn’t the fact that the US Federal Reserve Bank prints money out of thin air each and every day also a form of currency manipulation?

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Steven Adamou April 29, 2011 at 10:01 am

Hi, I am a first year economics student and I found this article to be quite misleading.
First and foremost, when the author says “Chinese imports may no longer be cheap enough to compete with American produced goods.” if the chinese stop manipulating the price of their yaun, suggests that they are ‘taking American jobs’ by doing this. Which is just not the case. If they were to discontinue their currency manipulation then input prices for firms in the United States would go up and we would have recession. How’s that for taking American jobs?

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Jerry November 3, 2011 at 10:01 am

After reading the article, the concept of currency manipulation still does not make sense to me. If the yuan is undervalued by the government of China, there is no one forcing Americans to purchase the yuan at the prices the Chinese government deems fit. It sounds like the American government wants to force the Chinese government to raise the price of the yuan, in order to ultimately force American businesses to buy the yuan at higher prices, which in turn discourages American businesses/consumers from buying Chinese products too.

If this is true, then I think American politicians need to convince Americans to simply buy American products. There’s no need to talk about currency values.

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Devon L Wilson February 1, 2013 at 9:41 am

Guys, this is a currency War! It will be the 3rd World War! Watch it plays out.. Inflation going to hit the US so bad, we will pull our hair out. The reason for China doing what she is doing, She would like to replace the US Dollar on the world market with the Yuan.

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