How China Influences the U.S. Dollar
China directly affects the U.S. dollar by loosely pegging the value of its currency, the yuan, to the dollar. China's central bank uses a modified version of a traditional fixed exchange rate that differs from the floating exchange rate the United States and many other countries use.
The People's Bank of China
The People's Bank of China manages the yuan's value. It keeps it fixed to a basket of currencies reflecting its trading partners. The basket is weighted toward the dollar since the United States is China's largest trading partner. It keeps the yuan's value within a 2% range against that currency basket.
On August 11, 2015, the PBOC modified this peg. The change uses a "reference rate" that is 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. The International Monetary Fund (IMF) required the PBOC to make the change. It was necessary before the IMF would consider the yuan an official reserve currency.
As of October 23, 2018, the U.S. dollar was worth 6.94 yuan. This valuation means that China's central bank guarantees it will pay 6.94 yuan for every U.S. dollar that a holder redeems.
Why China Fixes the Yuan's Value to the Dollar
China manages its currency to control the prices of its exports. It wants to make sure its exports are reasonably priced when sold in the United States. Every country would like to do this, but few have China's ability to manage it so well.
China's command economy allows it to control the central bank and many businesses. As a result, the Communist Party directs China's economy. The U.S. government regulates exchange rates instead of managing them.
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 their exports to the United States. The firms deposit the dollars into banks. In return, they receive yuan to pay their workers. The local banks then send the dollars to China's central bank, the People's Bank of China. It holds them in its foreign exchange reserves. By stockpiling dollars, the People's Bank reduces the supply of dollars available for trade. It puts upward pressure on the dollar's value, lowering the yuan's value.
The Changing Value of the Yuan
The PBOC uses the dollars to buy U.S. Treasurys. It needs to invest its dollar holdings into something safe that also gives a return. There's nothing safer than Treasurys. The current U.S. debt to China changes each month.
For example, China's 2015 modification to its exchange rate allowed the yuan's value to fall 2% to 6.32 yuan per dollar. The next day it dropped another 1% to 6.39. To restore the yuan's value, the PBOC used its dollar reserves to buy yuan from Chinese banks.
By taking yuan out of circulation, the Bank raised the currency's value. At the same time, it lowered the dollar's value by putting more dollars into circulation. By August 14, the yuan had recovered 0.1%, rising to 6.39 yuan per dollar.
On January 6, 2016, China further relaxed its control of the yuan. The uncertainty over the yuan's future helped send the Dow down 400 points. By the end of that week, the yuan had fallen to 6.5853. The Dow dropped more than 1,000 points.
By 2017, the yuan had fallen to a nine-year low. But China wasn't in a currency war with the United States. Instead, it was trying to compensate for the rising dollar. Between 2014 and 2016, the dollar rose 25 %. Because it was pegged to the dollar, the yuan followed it. China's exports became more expensive than those from countries not tied to the dollar. It had to lower its exchange rate to remain competitive. But by the end of the year, once the dollar fell, China allowed the yuan to rise.
How China's Economic Reforms Impact the Dollar
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% after hitting record highs 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.
China's Stock Market
China is the world's second-largest center of stock trading after the United States. But prices swing more than 10% within a day. That makes it one of the world's most volatile. It's so unstable because individual investors who are new to the market make up more than 80% of trades. Most Chinese are 100% 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.
The market is too risky for institutional investors like pensions and hedge funds. This makes it even more volatile. Also, China's government owns many of the companies that dominate the indexes. As a result, government policies affect the value of the companies it owns. Knowing this, many Chinese investors try to profit by outguessing the government's strategies.
China's leaders must slow economic growth to avoid inflation and future collapse. 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 it slows growth. China's leaders could create 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. 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 wealthiest 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 and trigger capital flight just the same.
Impact of China's Slowing Growth
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.