China Currency War

China and the US have been leading a currency war shortly after China started to enjoy the benefits of market economy. By keeping its currency artificially low, it can run a trade surplus and have a manufacturing advantage not only against the US but most countries, since the word reserve and trade currency is the USD, and the RMB is pegged to it. It is a well-known fact that PRC’s economic rise was accomplished by pegging the currency to the USD, by allowing it to float within 1% against the dollar, which also virtually eliminates FX risk.

Also the trading agreements between the US and China since Deng, who instituted these reforms, has boosted trade from $4 million in 1985 to $400 billion today, with US becoming its main trading partner. The mechanism by which china is undervaluing, or some say manipulating, its currency is not based on interest rates because interest rates is not a monetary tool in China unlike in the US. Instead of using the interest rate or allowing a free floating currency, the PRC central bank fixes the price of the currency against the dollar by increasing or decreasing the bank reserve requirements based on their policy i.

e. whether they want to reduce or increase the money available. The fixed exchange rate between the dollar and yuan obviously allows cheap imported goods from China which basically means that the US manufacturing becomes unprofitable to run. As a result, the politicians in Washington are pressured to force China to appreciate its currency since they claim China is protecting their trade superiority at the US workers expense. There are nevertheless benefits to having a strong currency against China as it allows lower price for consumers, lower inflation and lower input prices for US manufactures.

If the yuan had to become a free floating currency, it would hurt both US industries that rely on Chinese inputs, goods that compete with Chinese, and ultimately the consumer. Imagine an Iphone which is priced at around $600 and 90% produced and assembled in China with inputs from Asian countries, in a free floating environment it would cost at least 30%-50% more and it would be subject to FX fluctuations, a risk that is inexistent today and for which there are currently no hedging instruments available, which is also a cost.

Since 2005, the yuan has appreciated around 30%, which is still not representative of its true value against the dollar. China argues nevertheless that it cannot abandon its pegging policy otherwise an economic crisis would follow and not only for China but for other trading partners too. Fewer exports could also impacts on China’s ability to invest abroad, like in US treasury bonds for example, and the investments into China.

The solution to the problem obviously cannot be a radical one since it will dramatically impact global trade, prices, jobs and cause a turmoil in the financial markets, commodities and currencies. Everybody agrees that the current system cannot last forever and that it can be damaging to China in the long run. China has to gradually loosen its grip on the yuan, something that even the PRC central bank has stated it will do. HSBC estimates that within five years the yuan will be a free floating currency without however yielding complete control.

Global financial centres like London, Zurich, Chicago and New York are already negotiating with the PRC central bank to have the yuan trade within their exchanges, which shows a willingness of the Chinese towards that goal. As the Chinese economy becomes more mature with less poverty and middle class consumers, it would be in their best interest to have a stronger currency that will allow them to buy cheaper scare commodities and imported products and services, invest in human resources, innovation and knowledge.

The US will have to embrace these changes and accompany China without vilifying it. Although some manufacturing jobs will return to the US, it would be unwise to cheer because the risk is that may be some day China, with their financial resources attracting intelligent minds from all over the world, will be innovation center and the US and the rest of the world a workshop. View as multi-pages