China Currency Manipulation and Trade Implications

A topic that has been the source of friction between the US and China is the intentional undervaluation of the Chinese Yuan (also known as the Renminbi) by the Chinese government. This issue has gained traction after the global financial crisis in economic and political forums such as the G-20 as fundamental structural imbalances of global trade have been brought to light. In Washington the rhetoric against China has grown as the US faces an unprecedented fiscal deficit and a stubbornly high unemployment rate.

The Chinese government for the better part of the last three decades has pegged the Yuan to the Dollar, and utilizes a system of "Fixed Exchange Rate". From 1994 to 2005, one Dollar was equivalent to approximately 8.30 Yuan. During this period, the Chinese government blatantly disregarded market forces which were calling for an appreciation of the Yuan relative to the Dollar. Under pressure from Washington, the Chinese revalued their currency to 8.11 in 2005 and allowed it to slowly appreciate in a Managed Floating system. The Yuan was however re-pegged to the Dollar in 2008 in the aftermath of the global financial crisis. Currently, the Yuan traded at 6.5 to one Dollar. Even at this level, most economists argue the Yuan is undervalued by as much as 40%. At a 40% undervaluation, the Yuan should be trading in a "Flexible Exchange Rate" system close to 4 Yuan to a Dollar.

Why does the Chinese government intentionally devalue their currency?

China's economic growth story has been remarkable. It has grown at an average of 10% for the last thirty years and overtook Japan last year to become the second largest economy in the world. In terms of GDP, China is projected to overtake the US to become the world's largest economy by the end of this decade. This growth has primarily been driven by China's exports and specifically its exports to the US. In 1994, the US trade deficit with China was $29.5 billion. At the end of 2010, the trade deficit was a colossal $273 billion, reflecting a skewed trading relationship. This massive trade deficit is primarily due to the artificial undervaluation of the Yuan.

For instance, an US importer can exchange one hundred Dollars for 650 Yuan ($100 * 6.50) worth of goods at today's fixed exchange rate. If a t-shirt costs 50 Yuan, the US importer can buy 13 t-shirts. Now let's assume the Chinese government allows the exchange rate to appreciate to its market equilibrium of 4 Yuan to a Dollar (assuming a 40% undervaluation). In this scenario, the US importer will only receive 400 Yuan ($100 * 4.00) worth of goods for one hundred Dollars. With 400 Yuan the US importer can now only buy 8 t-shirts. US importers will buy fewer goods from China, weakening demand and look to other countries to import the same goods at lower cost. The Chinese exporter will also receive 250 (650 - 400) Yuan less in this case than with the fixed exchange rate.

China's export oriented growth model has lifted millions of people from poverty to a middle class standard of living. Despite this, a significant portion of the population still lives in rural areas where their sustenance is primarily based on farming. The Chinese are wary of moving to a floating exchange rate as this will mean the shuttering of thousands of export oriented businesses across China and result in large unemployment exacerbated by lack of social safety nets.

How does China "fix" the exchange rate?

In a nutshell, China sells its currency (Yuan) and buys US Dollars. At the end of 2010, China had a trade surplus of $273 billion with the US. This creates an excess supply of dollars, which in a flexible exchange rate system would have reduced the value of the Dollar relative to Yuan or in other words increase the value of the Yuan relative to the Dollar. Chinese exporters are mandated to clear their Dollar cash holdings through the Chinese Central Bank. The Central Bank exchanges the Dollars and provides Yuan, which it prints, to the exporters. It holds the Dollars as reserves and invests in Dollar denominated assets such as Treasury Bonds and US government backed mortgage bonds. Reducing the supply of the Dollars by mopping up the excess surplus of Dollars allows China to undervalue the Yuan relative to its true market equilibrium. China then issues bonds to reduce the supply of Yuan to decrease the potential for inflation and holds this as bank reserves.

What are the consequences of the Fixed Exchange Rate for China and USA?

China

1. Inflation - a phenomenon where more money chases the same number of domestic goods, leading to price appreciation. The inflation rate last month was 5.3% which is leading to severe monetary tightening and lower projected growth. This can be partially attributed to China printing Yuan to buy Dollars in order to keep the currency pegged along with other variables.

2. GDP growth solely reliant on exports of goods

3. Asset bubbles - value of real estate has sky rocketed. The total value of land of the cities of Beijing and Shanghai as calculated by China Economic Weekly based on the prevalent land price in 2010 is 30 trillion dollars. This is double the annual GDP of the USA. Again, this is partly due to the printing of Yuan to peg the currency.

4. FX reserve risk - as the value of the dollar depreciates, China's Dollar denominated reserves is worth less. China holds close to one trillion Dollars in US government debt and is often referred to cheekily as "America's Banker". China has lost 271 billion Dollars due to Dollar depreciation from 2003 - 2010.

USA

1. Leveraging of the consumer balance sheet - US consumers bought copious amount of Chinese goods from toys, furniture, and apparel fueled by credit card and home equity lines. This led to low US household savings and significant leveraging within the balance sheet of the consumer. Average credit card debt per household was $14,000.00 in 2010.

2. Leveraging of the public balance sheet - Like the American consumer, the US government leveraged its balance sheet - spending more money than it took in via tax receipts. Total US public debt outstanding is over 14 trillion dollars and approximately 96% of annual GDP as of the first week of May. China's demand for US debt has led to extremely low borrowing costs for the US government. The US Treasury can issue a 10 year note for a coupon at little over 3% today. The low interest rates undoubtedly played a role in both the Bush and Obama administration spending money liberally for their domestic priorities.

3. Huge trade deficit

4. Lower demand for US exports - US exports have lower demand in China due to weaker Yuan. A stronger Yuan would allow the Chinese consumer to buy more US goods. This has adversely affected the US manufacturing industry and plays a role in the high unemployment rate.

How can these complex, structural, fiscal and trade imbalances be resolved? There is no magic pill and the solutions outlined below will require time, patience and commitment from both sides.

1. A gradual appreciation of the Yuan / Dollar exchange rate to the market determined equilibrium. This will result in Chinese exports becoming more expensive to US consumers (lower demand) and US exports becoming cheaper for Chinese consumers (higher demand). This will eventually reduce the wide trade gap between both countries.

2. Due to a lack of social safety nets, the Chinese typically tend to save 50% of their disposable income. US household savings rate is 5.5% which is very low in comparison. The Chinese need to decrease their savings rate and increase domestic consumption to boost GDP instead of relying solely on the export driven model. In contrast, the US needs to increase its savings rate, de-leverage its private (consumer) and public balance sheets and consume fewer goods while producing more goods for export.

3. China needs to encourage domestic consumption of goods and reduce dependence on the US consumer for its exports and the US needs to aggressively grow its exports and reduce its domestic consumption which will help reduce the unemployment rate.

The Chinese and the US economies, the two largest in the world, are intertwined at the hip and will be the source of global economic growth for the foreseeable future. There is real danger that lack of structural re-balancing of the issues outlined above can lead the global economy back to a negative growth environment.