China periodically announces that it will float the value of the Yuan, which has traditionally been pegged to the U.S. Dollar. The Chinese central government has so far not made any serious changes. Many countries have legitimate reasons for a fixed exchange rate, but a large, economically powerful country like China should have the strength to maintain a stable currency in the open market without manipulation. Economists suggest the Yuan is undervalued by 15% to 40%, though it is hard to accurately conclude. The People’s Bank of China currently holds $3.2 trillion of foreign-exchange reserves.
How does China keep the Yuan weak? By buying US currency and treasury notes on the open market, China keeps demand for the US dollar high. They can afford to buy and hold so much US currency due to their huge trade surplus with America, and they buy US currency roughly equal to this surplus. To keep the influx of dollars from increasing the Chinese money supply, China “sterilizes” the dollar purchases by selling bonds to Chinese investors like commercial banks. By boosting the dollar, still one of the most powerful worldwide currencies, the Yuan looks weak in relation. For the last few years China has maintained the value of their currency at just under 7 Chinese Yuan to $1. Today $1 equals 6.54 Yuan. Something close to 5 Yuan to the dollar might be a better valuation based on other market factors.
Why should we care?
The cheap Yuan gives China an unfair advantage in the export market, encouraging the United States’ growing trade deficit with China and keeping goods in markets like India from competing locally.
Holding so much US currency gives China a lot of power over the dollar, and thus the US economy. What if China’s central bank decided to sell a large amount of US dollars and treasury notes all at once? The dollar could drop, leaving the US economy gasping for breath.
Unnaturally cheap goods and services from China hurt growing economies like India. India has a trade deficit of $19.2 billion with China. India has the potential to manufacture and sell lower priced goods, if the Rupee could compete with the Yuan.
By making other currencies relatively expensive, the booming Chinese population is discouraged from importing goods from other countries, including India, the United States, and Europe, because the cost is artificially inflated. This restricts a balance in trade and increases other countries trade deficits with China.
When currency is kept undervalued it leads to inflation, of which China suffers. As China powers their export economy through a weak Yuan, other sectors of their economy suffer. If the Chinese had to compete with goods and services on an even playing field, they may be forced to improve quality and safety. This would be good for their economy in the long run and improve the safety of goods world-wide.