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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