China's Currency, the Yuan or Renmimbi
Does China Manipulate Its Currency?
The yuan is China's national currency. It's known locally as the renminbi, which means "the money of the people." The renminbi is also the official name for the currency, while the yuan is a unit of the currency. It is pronounced as ‘yoo-ahn’.
The yuan has a critical role in keeping China's economy competitive. China has historically pegged the yuan to a basket of currencies filled mostly with the U.S. dollar. That means it kept the yuan's value in a 2 percent trading band around a "reference rate" that tracked the dollar's value. This was around 6.25 yuan to the dollar. In other words, one dollar could be exchanged for 6.25 Chinese yuan.
On August 11, 2015, China modified its policy to allow the yuan greater market volatility. It announced that the yuan’s "reference rate" would be equal to the previous evening's closing value on the foreign exchange markets. The dollar to yuan value immediately fell by 1.9 percent.
The next day the yuan dropped even further, to 6.3845. At that point, China intervened to control the rapid descent. It kept the yuan in a holding pattern of around 6.389 yuan to the dollar. By August 24, the rate had weakened to 6.4064 yuan per dollar.
The yuan continued to fall in 2016. On January 11, it was 6.58055. Investors panicked and sent the Dow down more than 1,000 points in the first week of the year. The government guided the yuan lower throughout the rest of the year. On October 1, 2016, it reached a six-year low of 6.7008. It continued to fall, reaching 6.9582 on December 18, 2016.
It strengthened for a short while in 2017, reaching 6.8432 on January 18. It fell again in the spring, then strengthened from 6.89 on May 24 to 6.794 by June 11, 2017. This only happened because China intervened to maintain the yuan's value. It assured markets that it would not let its currency weaken further against the dollar.
But the yuan is benefitting from the weakening of the U.S. dollar against the euro in 2017. It means the yuan has been weakening compared to China's other trading partners in Asia as well as its customers in Europe. That makes China's exports more competitive against its local rivals.
How China Manages the Yuan's Value
Exactly how does China maintain the yuan's value? The People's Bank of China is the country's central bank. It promises to redeem dollars for yuan at the current exchange rate. To do so, it must keep a good supply of dollars in its foreign exchange reserve.
Instead of holding dollar bills, it holds U.S. Treasurys, which can be sold fast for dollars. As China's economy grows, it must buy more and more U.S. Treasurys to meet the growing number of yuan being redeemed by its exporters. As a result, China is one of the largest foreign holders of U.S. Treasurys.
For example, the People's Bank intervened in 2015. To stop the yuan from falling further, it bought massive quantities of yuan. This ended up reducing the money supply. The contractionary monetary policy slowed economic growth by raising interest rates. To counteract this, the Bank did its own form of quantitative easing. It added 150 billion yuan, the equivalent of $23.44 billion, to banks' balance sheets.
China Is No More Guilty of Currency Manipulation Than Other Countries
Why did China change its policy? On November 30, 2015, the International Monetary Fund added the yuan to the world's official foreign exchange reserve currencies. This list also includes the U.S. dollar, the euro, the yen, and the British pound. It’s the first step for the yuan to replace the dollar as the global currency.
In 2013, China allowed British investors to invest $13.1 billion or 80 billion yuan in its capital markets. This move made London the first major trading hub for the yuan outside of Asia. China also allowed forex trading in Shanghai. These steps meant that the yuan became the 11th most traded, the eighth most used for foreign transactions, and the seventh among currencies in countries’ official reserve assets.
To truly let the yuan float, China must allow all its residents to hold foreign currency as well as buy foreign assets. This would allow the Chinese government to hold fewer dollars. It would also lessen the trade imbalance with the United States.
In February 2015, China held almost $1.2 trillion in U.S. debt. China often calls for a new global currency, including the yuan, to replace the dollar. It gets concerned when the United States threatens to default on its debt as it did in 2011 and 2013. China also worries when the dollar's value declines. It rattles its sabers like this whenever it sees its holdings of dollars lose value.
Between 2011 and 2014, China allowed the yuan to rise against the dollar. It responded to U.S. allegations of a currency war. It also wanted to keep its economy from overheating and creating inflation. As a result, on January 26, 2014, the dollar to yuan rate reached an 18-year high of 6.0487 yuan. Since then, the People’s Bank of China has allowed the yuan to weaken again in order to boost exports. This will strengthen China's economic growth. Because of economic reforms, the growth rate had been too slow.
China is the world's largest economy. In 2017, it produced $23.1 trillion in gross domestic product. This is more than the European Union or the United States. Its standard of living though, as measured by GDP per capita, is only $16,600. This is worse than some smaller countries, such as Iraq or Botswana. Chinese leaders want prosperity to rise so that the people are happy. It also needs to build its domestic market power to reduce its reliance on exports to the United States.
If China is guilty of currency manipulation, then so are many other countries. The United States was keeping the dollar low by maintaining interest rates at zero and accumulating the world's largest debt. This changed in 2014 when the dollar entered an asset bubble. Japan keeps its currency low by doing the same thing as China and buying dollars in the form of U.S. Treasurys. Even the EU has started lowering the euro by adopting its own form of quantitative easing. In other words, all exporting nations benefit from a weaker currency.
China's Yuan Policy Supports the Dollar Strength
Right now, the dollar is used as the currency of choice for most international contracts. All oil contracts must be transacted in dollars. This has been the case since the Nixon Administration took the dollar off the gold standard in 1973.
The dollar being the world's global currency is one reason why the U.S. debt has grown so large. It keeps the dollar in demand, thus keeping U.S. Treasury interest rates low. China's desire to keep the yuan low makes it buy U.S. Treasurys. This then keeps yields low, which helps the U.S. housing market by keeping fixed mortgage rates low as well. The Treasury note and mortgage interest rate relationship is a direct one. Low yields on Treasury notes translate to low interest rates on mortgages as well.
In theory, China could threaten to sell its U.S. Treasury holdings and put the value of the U.S. dollar into freefall. It's not in China's best interests to do so though. By threatening to sell U.S. Treasurys, China would quickly devalue its own holdings. Even so, it's been unwise for the United States to allow itself to become so indebted to any other country.