Definition: The Chinese yuan, also known as the renmimbi, is China's national currency. The yuan has an important role in keeping China's economy competitive. Why? China keeps the yuan pegged to a basket of currencies, most notably the U.S. dollar.
The yuan is worth a little more than fifteen cents. On January 26, 2014, it reached an 18-year high of $.1653. By the way, most forex traders look at the yuan/dollar exchange rate the opposite way. In other words, a dollar was worth 6.0487 yuan..
Since then, the yuan has reversed trend and weakened. China is seeking to allow greater market volatility as it controls the currency less. Since 2005, China had been allowing the yuan to gradually rise to slow export growth and offset inflation. (Source: WSJ, Investors Get Down With China's Currency, February 28, 2014)
Is China Guilty of Currency Manipulation?
Despite the yuan's controlled rise, many analysts think the Chinese government keeps the yuan artificially low. China does this to keep its products cheaper than U.S. products, thus increasing its exports to the U.S.
Some analysts say the yuan needs to rise 30% in value. They argue that if China allowed the yuan to float freely, it would be more valuable than the dollar because of China's strong economy. However, others argue that the yuan has already appreciated 25% against the dollar since July 2005.
The yuan has risen 6% annually, which converts to 10% due to China's higher inflation. This is a healthy rate of increase -- any more would have negative economic impacts for China. The country is desperately trying to keep its 1.3 billion people employed to raise their standard of living. China's leaders are afraid they will revolt if growth isn't fast enough.
Even though China is the world's third largest economy, ($13.37 trillion, right behind the European Union and the U.S.), its GDP per capita is only $9,800. This is worse than much smaller countries such as Jamaica or Cuba. (Source: CIA World Factbook, 2013 estimates)
If China is guilty of currency manipulation, then so are many other countries. The U.S. keeps the dollar low by keeping interest rates at zero and having the world's largest debt. Japan keeps its currency low by doing the same as China, and buying dollars. Even the European Union would like a lower currency. That's because all exporting nations benefit from a lower currency. For more, see Currency Wars.
How Does China Keep the Yuan at a Fixed Exchange Rate?
In a world of volatile foreign currency movements, exactly how does China maintain a fixed exchange rate? First, China promises to redeem dollars for yuan at the fixed rate. To do so, it must keep a good supply of dollars in reserve. Instead of holding dollar bills, it holds U.S. Treasuries, which it can quickly sell for dollars. As China's economy grows, it must buy more and more U.S. Treasuries to meet the growing number of yuan. As a result, China is the largest foreign holder of Treasuries.
In August 2013, China held more nearly $1.3 trillion in U.S. debt. This makes the U.S. a little more vulnerable to China's political pressures. China often calls for a new global currency to replace the dollar. China gets concerned when the U.S. threatens to default on its debt, like it did in 2011 and 2013. China also worries when the dollar's value declines, a result of the U.S. flooding the world with dollars to boost is own economic growth. China rattles its sabers like this whenever it sees its holdings of dollars lose value.
China's Yuan Policy Keeps the Dollar Strong
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 U.S. went off the gold standard in 1973.
The dollar being the world's global currency is one reason the U.S. debt has grown so large. It keeps the dollar in demand, thus keeping Treasury interest rates low. China's desire to keep the yuan low makes it buy U.S. Treasuries. This keeps yields low, which helps the U.S. housing market by keeping mortgage rates low. For more on how this works, see The Relationship Between Treasury Notes and Mortgage Interest Rates.
China's Yuan Policy Is Changing
China could, theoretically, threaten to sell its Treasury holdings, putting the value of the U.S. dollar into freefall. However, it's not in China's best interests to do so. By threatening to sell U.S. Treasuries, China would quickly devalue its own holdings. Even so, it's been unwise for the U.S. to allow itself to become so indebted to any other country.
In 2013, China allowed British investors to invest $13.1 billion, or 80 billion yuan, in its capital markets. It will make London a major trading hub for the yuan, the first outside of Asia. China has also allowed some limited forex trading in Shanghai. These steps means the yuan is now the ninth most traded currency, giving it a higher global profile. China may yet follow through on its threat to make the yuan the world's reserve currency, replacing the euro and the dollar. (Source: WSJ, U.K., China to Increase Yuan's Role, October 16, 2013)
To let the yuan freely float, China should allow all its residents to hold foreign currency and buy foreign assets. This would allow the Chinese Government to hold less dollars and lessen the trade imbalance with the U.S. Then there would be less focus by the U.S. Congress calling for an increase in the yuan's value. See more about China's economic growth and steps to reform its economy. Article updated December 11, 2013