What is currency manipulation?

October 21, 2018

One recent piece of economic news was that China was not labeled a currency manipulator in the eyes of the United States. Since then, the RMB has dropped to its lowest level against the dollar in over a year.

The Donald has been calling China a currency manipulator since the election. Why does China want to have a weak currency? What good does it do to place a label on China as a currency manipulator? How do you manipulate currency? Is Donald right?

TL;DR: To make exports cheap. None. Adjusting the money supply. No.

China, for over twenty years, has been a net exporter of goods to the rest of the world. This was a huge part of Deng Xiaoping’s “Socialism with Chinese characteristics” policy. China would industrialize, and industrialize quickly, taking advantage of its behemoth workforce to make products for the rest of the world. Initially, it was real cheap to buy products from China because its people were still in poverty, reeling from Mao’s Cultural Revolution. The labor force was just struggling to put food on the table at home. As a result, foreign nations kept pumping money into the Chinese system. Dollars and euros and pounds (but mostly dollars) flow into the Chinese economy to purchase these goods. This, in turn, produces growth in the Chinese economy. All of these dollars are exchanged for RMB to pay workers. Since so much of this USD -> RMB exchange is happening, one would expect the normal laws of supply and demand to kick in. The price of the RMB should go up. It doesn’t.

China wants to keep its currency undervalued so that it can remain a net exporter of goods. For people in China, this means that leaving the country and buying foreign goods can be prohibitively expensive. This is one of the reasons why American-made cars are often viewed as luxury goods in China. But instead of letting their currency float, the People’s Bank of China would take the influx of dollars from trade and exchange them for RMB at a fixed exchange rate. The People’s Bank can do this essentially because they print the money. With these dollars, the PBOC can go out and buy some more US treasuries, adding to the US debt to China.

China can also control the value of its currency by selling and buying domestic bonds and adjusting the reserve ratio and discount rate. Each of these methods affects the money supply in the system, which in turn affects its forex rates.

Over the past decade, the RMB has been a mixture of a fixed-rate currency (when the exchange rate with the US was essentially flat) and a “managed float” currency. It’s a pseudo-floating currency that will occasionally see government intervention in the name of “market forces” that justify the devaluation of the currency. “Market forces” refer to the failure to meet ambitious growth targets of 6-8% over the year. In order to meet those growth targets, the government did the logical thing and spurred on the economy by reducing interest rates and devaluing the currency. This is at least somewhat justified. China, as an export-driven economy, needs to maintain growth by providing competitive prices on goods. On the other hand, it is very artificial, leading Chinese people to be more dependent on the domestic economy and less able to purchase foreign goods.

As China continues to devalue the currency, Chinese goods continued to be cheap, leading to more foreign inflows. This inflow of foreign money puts upward pressure on the yuan, and so China needed to infuse more yuan into the money supply. This cycle feeds itself, leaving the PBOC in a bit of a pickle today.

In labeling China a currency manipulator, pretty much nothing actually happens. Any review that the Treasury will conduct under the new label would have been done anyway. For Donald, it’s fulfilling a campaign promise. For the rest of the world, it’s stoking more tensions that don’t need to exist in the first place.

The trade war over the last several months has caused a depreciation in the value of China’s currency, as China makes its goods cheaper to compete in the American market with the tariffs. This only devalues the RMB even more.

In 2015, the IMF announced the addition of the RMB to the reserve currency list. At the same time, it wasn’t yet fully ready to embrace the yuan. Neither are investors - the fact that PBOC policy influences the value of the yuan as much as it does means that investors and governments are wary of keeping their money in yuan. In a normal economy, keeping yuan would be fine, because the value of the RMB would rise against other currencies. But with the depreciation in value of the RMB combined with a slowdown in growth of the Chinese economy, many are not interested in keeping the RMB. As you find in any country/corporation, laws of big numbers come into play - you can’t sustain 6%+ of growth year over year forever. More recently, China has been coming to terms with this fact, and as a result need to reconsider the structure of the economy.

Even Chinese individuals are trying their best to get money out of yuan. The Chinese government imposes a $50,000 USD foreign exchange outflow quota for individuals. For wealthy Chinese families, this is only a small barrier in getting their money out of RMB. Many will use their quotas in combination with extended friends and family’s quotas to go invest in foreign real estate, bonds, and other markets. Fraudulent papers and accounts can also be used to transfer money out of yuan.

As a side note, the sentiment on the RMB is another reason why wealthy Chinese often turn to real estate - one of the few investments with firm value and growth projections that coincide with Chinese growth targets.

As Chinese investors and companies look outside China for investment opportunity, the demand for the yuan decreases, putting downward pressure on its value. In order to prevent a complete collapse of the currency, China began digging into their forex reserves. This means selling dollars and buying yuan, to increase the supply of the dollar and reduce its value against the yuan. This is propping RMB up in value. Donald says that the RMB is undervalued. In reality, it’s probably overvalued right now.

Suppose the PBOC just went hands off on the RMB right now, letting it float. No outflow quotas, no money supply manipulation, no selling of USD reserves. Market forces would decide the value of the RMB. As a result of China’s slowing economy, we could see the RMB plummet in value. This would likely send a shock through the Chinese economy. But at some point, the PBOC can’t sustain this much longer.

China needs to come to terms with the fact that it can no longer focus on an export-driven economy. They’ve progressed admirably through the stages of industrialization and development, and need to start acting like a grown-up. They need to let their currency float properly, open markets up to both inflows and outflows, and allow Chinese people to participate in the global marketplace. In the long term, this is the only way to ensure that China maintains some amount of growth sustainably.

Here is a cool infographic on how the (downward) currency manipulation works.

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