What’s Going on With the Chinese Yuan and US Dollar?

It often seems that China and the US are in a constant tug-of-war over the relative values of their two currencies. US lawmakers are constantly pointing at China for keeping the yuan artificially low, while China largely rejects these claims and continues to control the value of its currency at the same time.

While it may seem relatively clear that China is manipulating its currency – it pegs the value against the US dollar and then allows a 1% variation – the situation is not as simple as it seems.

A low yuan is not necessarily bad

First of all, the dramatic economic growth that China has seen over the last three decades is due to its huge increase in exports. Raising the yuan would undermine this growth, which is clearly not an option for China. At the same time, the US consumer benefits from cheap goods, raising the overall standard of living and keeping inflation under control. China is also generating massive dollar profits, which it is rolling back into the US through the purchase of treasuries – helping to finance the enormous current-account deficit in the US.

At the same time, China has to be wary of the implications of a rapid upwards revaluation of the yuan. There is historical precedent for the damage this can do – when Japan did a similar thing with the yen under pressure from the US, this was followed by a decade of economic stagnation in the country. Also, any massive increase in the yuan would significantly reduce the value of Chinese holdings in the US – for instance, it has been estimated that they would lose $130 billion on US treasury bills alone.

However, there are significant downsides

While US consumers may benefit from inexpensive imports, there is clear evidence of the damage that the low yuan has done. According to some reputable sources, the US has lost 2.7 million jobs in the last decade because of the low yuan, with most of these losses coming in the manufacturing sector. This translates into about $37 billion in lost wages every year.

There are also concerns for China’s own economy. Clearly, it cannot rely on Europe and North America to continue to take increasing imports from China each year, particularly since doing this is having a negative effect on these economies. It needs to develop its domestic market to drive continued growth – but the low yuan drives investment in Chinese export manufacturing, while the domestic market continues to be underserved. The low yuan also makes imports more expensive, again limiting the potential of the domestic market.

The way forward

China has indicated that it is putting a much stronger focus on the domestic market, and also has said that it is not looking to grow its foreign currency reserves significantly at this point. Both of these indicate that China may gradually increase the value of the yuan over time, which means that the situation may start to resolve itself.

In the short term, it is clear that ratcheting up US economic pressure on China is likely to be counterproductive. A trade war between the world’s two largest economies would do far more damage than a gradual rebalancing of exchange rates between the two countries.

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