Congress in last couple of years has stressed more and more to pressure China to ease restrictions on its currency. In my post about currency exchange, I explained how the value of currency affects exports and imports of a country. Based on that discussion, we know that when a currency is devalued, its exports increase. So when China undervalues its currency, it helps keeps Chinese products cheap and helps its exports.
In my post about currency exchange I explained how foreign exchange market determines the price of a currency. So how is it that the price of Chinese Yuan is not determined by the foreign exchange market. The answer is because Chinese government through People's bank of China controls how much Yuan is going to flow into the market, effectively controlling the price of Yuan.
Let's see this through an example. Assume there is a factory in China that supplies some product X which is sold to the US. Now the US buyer will make its payments in USD to this factory for the product X. But this factory needs Yuan to pay its employees, to buy raw material (if its not imported), pay for factory bills, taxes and other similar expenses. So the factory will go to People's bank of China and exchange its USD for Yuan. This is where Chinese government control comes in and it decides the price of Yuan. This USD, and similar hundreds of millions (billions per year) end up in Chinese reserves and significant portion of this USD is used to buys US government bonds, making Chinese government the biggest, US lender.
Now that we know how Chinese government controls the price of Yuan, how does it affect (hurt/benefits) US. First of all, for no change in income of American consumer they can buy more Chinese goods because they are getting more Yuan than they would in a freely traded Yuan in a foreign exchange market. So American consumer is better off. Then why does Congress and White house has an issue? Because Congress or White house are not there to help american people. They are there to help those who fund their campaigns. While American people are better off when Chinese government undervalues its Yuan, the American business which is competing against a Chinese business is worse off. So these businesses combine together lobby the government and push for pressure on Chinese government to reevaluate its currency against dollar. This will hurt American consumer because Chinese goods will increase in price but will help American businesses as it would be easier for them to compete now.
This in a nut shell is how Chinese government undervalues its currency and how it affects its trading partners, the biggest of which is US. If you ask me, I'd say let them undervalue their currency as it helps me get cheap products from China.
You started off by saying that US consumers of chinese goods pay chinese companies in USD. Later you said they pay in Yuan. I'm confused.
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ReplyDeleteThank you for your comment Raj. I can't find the lines you may be referring to. Can you please tell me the exact text. But basically this is how it works. You pay in USD to let's say Walmart (just an example, can be any store). Walmart in turns pay to it's supplier in China in USD (there can be many layers). That supplier needs Yuan so it gets Yuan from People's bank of China. So effectively you as a consumer supply US dollar in the foreign exchange market, there by increasing its supply. And you as a consumer increases the demand of Yuan because if you were not buying that product then that Chinese factory will not get the dollars and it will not need to exchange those dollars for Yuan. So while you make a payment in dollars, you are effectively the one who is making that payment in Yuan. Is it still confusing? Please let me know.
ReplyDeleteIt requires much less data than fundamental analysis. From price and volume, a technical trader can obtain all the information he needed.
ReplyDeleteChina is using the same monetary practice the Reagan administration used to undervalue the dollar against Japan.
ReplyDeleteThe effects on the U.S. will be no different than the effects felt by Japan in the 80's and 90's. Japan stills struggles with this problem as they were basically pushed out of the export business because of poor U.S. monetary policy. This policy hurt Americans because forever after because our dollar has been so devalued it simply cannot purchase foreign goods in the way it used to.
China undervaluing its currency allows them to sell to everyone cheaper. I wonder, during the 2012 U.S. Presidential debates, if Mitt Romney realized he was criticizing China for a practice used by the Republican demigod, Reagan.
Thanks for your comment. Actually, I was trying to just describe how it actually does that. I didn't went into its effects. I am no Reagan fan. However, its Federal Reserve that controls the supply of US dollar and not a US president (granted they will appoint the chairman of the fed). However, Federal Reserve since last recession in its effort to control prop up the labor market have devalued the dollar. So in all fairness, whatever China is doing shouldn't be cried a foul as it is not much different from what Federal reserve is doing, albeit in a more democratic manner.
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DeleteHi Saifurrahman
DeleteThe question you asked and later deleted was "why China is not interested in increasing the value of its currency".
The answer is, it will make its exports expensive which means its exports will be reduced.
thanks Imad,
Deletereally appreciate it ,But still it is uncleared to me .We know that when export is increasing the value of currency is going up and revers of this in any country .why china is not allowing to increase it currency's value ...?and what is the relation ship of export and import with currency values...
thanks .
awaiting .
Hi Paiman
DeleteBecause when the value of your currency goes up, everything you are selling becomes expensive in international market and your buyers may have cheaper options elsewhere. So China would like to keep value of its currency low, so its businesses are able to offer competitive prices in international market. I think you should read my post on "How currency exchange works" http://imadqureshi.blogspot.com/2011/12/how-currency-exchange-works.html
Thanks a lot Imad ,I understood really appreciate it .
DeleteThank you imad, I should appreciate your knowledge of economics. I have a doubt which requires clarification and would be glad if you take interest in it. If China devalues it currency then inflation is ought to increase and will ultimately lead to price rise. Don't you think under such situations the domestic market of China is ought to suffer. Why this doesn't happen?
ReplyDeleteHi Divank
ReplyDeleteThat's actually a really good question. I'll try my best to answer but you should do some more research to find a better answer if you could. Here is what I think.
Assume that China is not undervaluing it's currency. What do you think will happen in this case? Please do think for a moment and come up with some answer before reading further.
We know China's value of currency will go up. It will make Chinese goods expensive. Internally in China, people will have less money because now their exports are going down. However, that's less money is actually worth more. We don't know how much more. but definitely more than it would compared to China devaluing the currency.
Now, I think what China's is very smartly doing is devaluing the currency, to a point where the exports are competitive and inflation is within the target they want. Notice they had deflation in 2009, which tells me that right after the crisis, they didn't devalued the currency as much as they should have to support their growth.
Finally, US federal reserve policy has been to keep interest rates zero bound since 2009 and has also pumped I believe over a trillion dollar in three different QE programs and yet we don't see that reflect in inflation yet. So I am not surprised that China's devaluation does not result in uncontrolled inflation.
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Thanks Imad. This has been my question for quite long time. Dosen't China earn less money by selling Chinese goods cheap? Like a company, it always wants to sell their product as high as enough to earn more profit. I always think China devaluate its currency would hurt China as they earn less.
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