Dollar Yuan Peg

China has become the largest exporter of goods in the world. This has been a remarkable feat achieved by the Chinese given the fact that just a couple of decades back, their economy was in complete shambles.

Part of this feat can be attributed to the world class infrastructure that China has built to enable low cost production. However, a significant part can also be attributed to the currency policy that has been followed by the Chinese.

In this article, we will discuss about the currency policy of China in recent times and how it has affected the Forex markets:

Maintaining a Currency Peg

The most significant aspect of Chinese foreign trade policy is its decision to maintain a currency peg with the United States. This means that the Chinese Central Bank has publicly announced that it will always maintain its currency at a fixed rate as compared to the United States dollar.

Hence if the US dollar appreciates 5% in the market, the Chinese central bank will ensure that the currency rate between the dollar and the Yuan still remains unchanged.

The Chinese central bank actively manages the currency peg. This means that they buy and sell dollars in the open market and even resort to printing more Yuan if required to maintain a stable exchange rate with the dollar.

Exporting More

The idea of maintaining a stable dollar is rooted in the Chinese vision of being an export leader. United States is the largest importer in the world and China wants to capture that market. They can only do so if their producers target the United States market and have a stable base to do so.

Since the Chinese government has pegged the dollar to the Yuan, they have removed the volatility from the calculations of the exporters. As such, exporters are assured of the revenue that they will make in Yuan terms if they export a certain amount of goods in dollar terms.

Also, when a country exports more, it witnesses appreciation in its currency. This appreciation makes production of goods expensive relative to foreign markets and slows down the exports. However, the peg has ensured that the Chinese currency remains at the same level despite the increasing exports.

The currency peg with the dollar has therefore been the stronghold of the Chinese exports. Whether it has benefitted the Chinese economy? The results are yet to be seen. However, it has enabled China to dominate the export markets for a couple of decades now!

Absorbing Excess Dollars

The currency peg ensures that China also has to create more inflation in order to match the inflation that has been created by the United States.

Consider for example that China conducts a lot of trade with the United States. As a result a lot of goods produced in China end up in the United States. The United States prints more dollars and clears off the fiscal imbalance.

More dollars created means that the price of the dollar will depreciate against the yuan. However, the Chinese government has to maintain the peg. Therefore, in order to maintain the fixed rate, Chinese central bank creates more yuan. This ensures that an increased supply of dollars is matched by an increased supply of the yuan!

Hence, this unhealthy trading relationship between these two countries is not only causing trade imbalances that were unheard of in the past, but also creating massive inflation in both the countries.

Buying US Treasury Assets

The Chinese therefore end up with a lot of dollars as a result of the trading. They do not have too many options to invest those dollars. As a result, they end up buying the safest dollar denominated asset that there is i.e. the United States treasury bonds.

Thus, the United States can borrow from the Chinese at rock bottom interest rates, the very same money that they lent out in the first place.

The Process Repeats

The entire process mentioned above has been repeating itself in an endless loop. The Chinese have been selling goods to the United States, receiving payments in dollars and then investing the same dollars in United States treasury securities for about a couple of decades now.

The results have been catastrophic for both China and the United States. They are now stuck in a position where neither party can unwind without suffering major losses.

The story of the dollar yuan peg is therefore the story of how Forex markets have been manipulated by certain countries in order to gain an export advantage.

In the short term, manipulating currency might seem to be an advantageous strategy. However, in the long run it causes more issues than it solves.