How Does China Influence the U.S. Dollar?

China's influence on the dollar, as represented by flags
China influences the dollar by buying U.S. Treasuries. Photo: grahamheywood/Getty Images

China directly affects the U.S. dollar by loosely pegging the value of its currency, the yuan, to the dollar. As of January 26, 2017, the U.S. dollar was worth 6.88 yuan. This exchange rate means that China's central bank keeps the yuan's value around that level. The bank guarantees it will pay 6.88 yuan for every U.S. dollar that a holder redeems.

Until August 2015, China used a modified version of a traditional fixed exchange rate.

The United States and many other countries now use a floating exchange rate. China’s exchange rate compared the yuan's value to a basket of currencies reflecting its trading partners. The basket was weighted towards the dollar since the United States is China's largest trading partner. It kept the yuan's value within a 2 percent range against that currency basket. China managed its currency to control the prices of its exports. Every country would like to do this, but few have China's ability to regulate it so well. Here's more on How the Government Regulates Exchange Rates.

How China Manages Its Currency

China's currency power comes from its many exports to America. The top categories are consumer electronics, clothing and machinery. Also, many American companies send raw materials to Chinese factories for low-cost assembly. The finished goods are considered imports when the factories ship them back to the United States.

That's how the U.S. trade deficit with China is profitable to American companies.

Chinese companies receive dollars as payment for its exports to the United States. The companies deposit the dollars into banks in exchange for yuan to pay their workers. Banks then send the dollars to China's central bank, the People's Bank of China.

It stockpiles them in its foreign exchange reserves. That reduces the supply of dollars available for trade. It puts upward pressure on the dollar's value, lowering the yuan's value.

The PBOC uses the dollars to purchase U.S. Treasurys. It needs to invest its dollar holdings into something safe that also gives a return, and there's nothing safer than Treasurys. The current U.S. debt to China changes each month.

On August 11, 2015, the PBOC modified its peg to the dollar. It based the yuan's value on a reference rate. This rate was equal to the previous day's yuan closing value. The PBOC wanted the yuan to be more driven by market forces, even if it meant greater market volatility. One reason the PBOC made this change was the International Monetary Fund required it for the yuan to be considered an official reserve currency. (Source: "The Yuan and the SDR," The Economist, August 5, 2015.)

That allowed the yuan's value to fall 2 percent, to 6.32 per dollar. The next day it fell another 1 percent to 6.39. To restore the yuan's value, the PBOC used its dollar reserves to buy yuan from Chinese banks. First, that lowered its value by putting more dollars into circulation. But by taking yuan out of circulation, it also raised its value.

 By August 14, the yuan had recovered 0.1 percent to 6.39 per dollar.

How China's Economic Reforms Impact the Dollar

China's economy impacts the dollar's value in other ways. China's slowing economic growth and potential credit problems are two reasons why the dollar gained strength in 2014.

China's stock market experienced an asset bubble that burst in early July, sending the exchanges into a correction. Stock prices fell more than 30 percent after hitting record highs on June 12, 2015. More than 700 companies listed on the Shanghai and Shenzhen stock exchanges asked to suspend trading. This was almost a quarter of all firms.

(Source: "China Firms Rush to Halt Trading As Stock Market Slumps," CNBC, July 7, 2015.)

China is the world's second-largest center of stock trading after the United States. But prices typically swing more than 10 percent within a day. That makes it one of the world's most volatile. It's so volatile because individual investors who are new to the market make up more than 80 percent of trades. Most Chinese are 100 percent responsible for their retirement funds. The government doesn't provide anything like Social Security. They feel they must "outperform the market" to boost their retirement earnings.

In fact, the market is too risky for institutional investors like pensions and hedge funds, making it even more volatile. Unlike the United States, China's government itself owns the biggest companies that dominate the indexes. That means government policies, regulations and even announcements affect the value of the companies it owns. Knowing this, many Chinese investors try to make money by outguessing the government's strategies and statements. (Source: "Why Are China's Markets So Volatile?" CNBC, July 7, 2015.)

China's leaders must slow economic growth to avoid inflation and a future collapse. That's because they've pumped too much liquidity into state-run companies and banks. In turn, they've invested those funds into ventures that aren't profitable. That's why China's economy must reform or collapse.

But China must be careful as they slow growth. China's leaders could create a panic as some of these unprofitable businesses shut down. Bank loans support almost a third of China's economy. Almost a third of these loans are above the lending limits set by the central government. That's because they aren't on the books and aren't regulated. They could all default if interest rates rise too fast or if growth is too slow. China's central bank must walk a fine line to avoid a financial crisis

China's mega-rich want to escape this threat. They are investing in U.S. dollars and Treasurys as a safe haven investment. The richest 2.1 million families control between $2 trillion and $4 trillion in stocks, bonds and real estate. China's leaders must be careful in devaluing the yuan to prevent more capital flight. At the same time, it can’t keep the yuan's value too high either. This will slow the economy too much, triggering capital flight just the same. (Source: Andrew Browne, "Megarich Keep Eyes on Yuan," Wall Street Journal, February 25, 2015.)

There is another reason China needs to be careful with slowing growth. Emerging market countries rely on exports to China to fuel their growth. As China's growth slows, it will hurt some of these trade partners more than others. As these countries’ exports slow, so will their growth. Foreign direct investment will drop as opportunities dry up. Slowing growth weakens these countries’ currencies. Forex traders may take advantage of this trend to drive currency values down more, further strengthening the dollar.