How is yuan valued

Leave aside for the moment whether these oscillations are the result of Chinese government policy or market forces. In the current context, exchange rates can either intensify the pain of tariffs or relieve them. Tariffs are assessed when an imported good enters the country imposing them, paid by the importer, be that a carmaker, a clothes retailer, or Apple.

The logic of tariffs is that the higher price makes it less attractive to import from China. To date, the tariffs have affected mostly industrial goods and not direct consumer products such as shoes, furniture, or iPhones. It could raise prices, seek to cut costs, or accept less profit.

The same formula applies to all imports from China—Nike sneakers, KitchenAid appliances, home routers. While it appears a win for consumers around the world - who can now buy Chinese products more cheaply - it carries other risks. A weaker yuan will also make imports into China more expensive, potentially driving up inflation and creating strains in its already slowing economy , as well as pushing currency holders to invest in other assets.

Back in , China's central bank pushed its currency to its lowest rate against the US dollar in three years, in part to deal with easing growth. The central bank said the move was designed to support market-reforms. The last time the yuan traded at the 7-level against the dollar was during the global financial crisis. Capital Economics Mr Evans-Pritchard said China has long argued the 7-per-dollar level is an arbitrary threshold, "but had previously intervened to prevent the currency from breaching this threshold".

Making Chinese goods more competitive strikes at the heart of Mr Trump's trade war with Beijing. The US president has long accused China of devaluing its currency in order to support its exports - claims Beijing has denied. Despite linking the latest slide in the yuan to the trade war, China continued to state it would not engage in "competitive devaluations". Currency manipulation - by China or any other other country - is seen to flout global trading rules by conferring unfair competitive advantages.

This viewpoint is backed by the fact that most nations in the modern era, notably the Asian Tigers, have achieved sustained increases in per-capita incomes for their citizenry mainly through export-oriented growth. As a result, China has consistently resisted calls for a substantial upward revision of the yuan, since such a revaluation could adversely impact exports and economic growth , which could in turn cause political instability.

Demands in recent years by U. According to a study by the Economic Policy Institute in , the U. Implications of Yuan Revaluation.

On the one hand, the undervalued yuan is akin to an export subsidy that gives U. As well, China recycles its huge dollar surpluses into purchases of U. Treasuries, which helps the U. On the other hand, the low yuan makes U. As noted earlier, the undervalued yuan has also led to the permanent transfer of hundreds of thousands of manufacturing jobs out of the U. A substantial and abrupt revaluation in the yuan, while unlikely, would render Chinese exports uncompetitive. Although the flood of cheap imports into the U.

Yuan revaluation may do little to stem the exodus of U. Mitigating Factors and Glimmers of Hope. There are some mitigating factors and glimmers of hope on the issue of yuan revaluation.

A number of analysts maintain that one reason for the huge increase in U. Specifically, a significant proportion of these imports are from multinational companies based in China that use facilities located in the nation as the final assembly point for their products. Many of these companies have moved their production facilities from higher-cost nations such as Japan and Taiwan to China.

Finally, concerns that China may dump its holdings of U. Treasuries in the event of yuan revaluation seem largely overblown. The Bottom Line. Estimates of the RMB's undervaluation are typically defined as the appreciation that would be required for China to attain "equilibrium" in its current account balance. But there is no consensus based on theory or evidence to determine what equilibrium would be, so a judgmental approach is used.

As indicated in Figure 8 , Cline's estimates of the amount of appreciation the RMB would need to obtain equilibrium i. His May study estimates the equilibrium level of the currencies of 33 countries plus the euro area. The top 10 countries with the most undervalued currencies as of April are listed in Table 1 in ranking order.

Table 1. Source: Cline, William R. There is no universally accepted methodology for precisely determining a country's real market exchange rate. The economic conditions and assumptions that are used to determine "equilibrium" exchange rates change continuously. As a result, many analysts question their usefulness to U.

Figure 8. Source: William R. Many policymakers might expect that if China significantly appreciated its currency, U. For example, C. On the one hand, during this period U. Part of the problem in attempting to evaluate the effects of the RMB's appreciation is that it can take time perhaps a few years before changes in exchange rates are reflected in changes to prices of tradable goods and services, and, hence, result in changes to imports, exports, and trade balances.

An appreciated RMB could actually worsen the U. It would take time for U. If an appreciated currency lowered prices for U. Over time, one would expect the effects of currency appreciation to affect the flow of bilateral trade and, possibly, produce a decrease in the bilateral trade imbalance although the size of the overall U.

Another factor to consider in evaluating the effects an RMB appreciation may have had on trade flows is to examine how price changes would be passed on or distributed. If the RMB appreciates against the dollar, not all of the price increase resulting from the appreciation may be passed on to the U. Some of it may be absorbed by Chinese laborers, producers, or exporters, and some by U. According to the U. Department of Labor, from to year-end , the price index for U. Figure 9. Index of U.

Note: is the first available year for data on import prices of Chinese commodities. The issue of exchange rate effects is further complicated by China's role as a major assembly center for multinational corporations.

Many analysts contend that the sharp increase in U. That is, various products that used to be assembled in such places as Japan, Taiwan, Hong Kong, etc. According to Chinese data, foreign-invested firms in China account for over half of China's trade flows both exports and imports.

Such firms import raw materials, intermediate goods such as components , and production machinery to China. One study of Apple Inc. Others contend that, even if foreign-invested firms in China faced significantly higher costs because of an appreciated RMB, they would move production to another low-cost country, and thus, while the U.

S trade deficit with China decreased, the U. By accounting identity, the overall trade deficit is equal to the shortfall between domestic saving and investment, while an overall trade surplus is equal to a surplus of domestic saving relative to investment. For many years, China has been a high-saving country that has run overall trade surpluses and the United States has been a low-saving country that has run overall trade deficits for more discussion on this issue, see Appendix.

China's use of an exchange rate peg and capital controls may have contributed to its high saving rate, but it is unlikely that movement to a floating exchange rate would eliminate the large disparity between U. Thus, it is likely that the United States would continue to be a net debtor and China would continue to be a net creditor if the RMB rose in value. If so, economic theory predicts the countries' bilateral trade imbalance would either persist or possibly be replaced by new bilateral imbalances with third countries.

As noted earlier, a number of U. However, other economists contend that, while an undervalued RMB may have distorted trade flows to some extent, it is not the most significant challenge to U. For example,. Economists generally oppose the use of policies such as subsidies and trade protection that interrupt market forces and distort the most efficient distribution of resources. A fixed or managed float exchange rate whose level is not adjusted when economic conditions change might be viewed as such a distortion.

From a policy perspective, it could be argued that China's current undervalued currency produces economic "winners and losers" in both countries, and therefore, an adjustment to that policy would produce a new set of economic "winners and losers. What would the effects be for the U. When exchange rate policy causes the RMB to be less expensive than it would be if it were determined by supply and demand, it causes Chinese exports to be relatively inexpensive and U.

As a result, U. A market-based exchange rate could boost U. According to economic theory, a society's economic well-being is usually measured not by how much it can produce, but how much it can consume. An undervalued RMB that lowers the price of imports from China allows the United States to increase its consumption through an improvement in the terms-of-trade.

Since changes in aggregate spending are only temporary, from a long-term perspective, the lasting effect of an undervalued RMB is to increase the purchasing power of U. Imports from China are not limited to consumption goods. An undervalued RMB lowers the price of these U.

An appreciation of China's currency could raise prices for U. In addition, firms that use imported Chinese parts could face higher costs, making them relatively less competitive. An undervalued RMB also has an effect on U. When the United States runs a current account deficit with China, an equivalent amount of capital flows from China to the United States, as can be seen in the U.

This occurs because the Chinese central bank or private Chinese citizens are investing in U. Capital investment increases because the greater demand for U. This increases aggregate spending in the short run, all else equal, and also increases the size of the economy in the long run by increasing the capital stock.

The effect on interest rates is likely to be greater during periods of robust economic growth, when investment demand is strong, than when the economy is weak.

Private firms are not the only beneficiaries of the lower interest rates caused by the capital inflow trade deficit from China. Interest-sensitive household spending, on goods such as consumer durables and housing, is also higher than it would be if capital from China did not flow into the United States. In addition, a large proportion of the U. Treasury securities, which fund U. Treasury securities as of May , making it the largest foreign holder of such securities.

During this period, while the Obama Administration pushed China to appreciate its currency, it also encouraged China to continue to purchase U. Some analysts contend that, although an appreciation of China's currency could help boost U. Treasury securities, which could push up U. In the unlikely worst case scenario, if China stopped buying Treasury securities at a time when the U. In the medium run, according to economic theory, an undervalued RMB neither increases nor decreases aggregate demand in the United States.

Rather, it leads to a compositional shift in U. Thus, it might be expected to have no medium- or long-run effect on aggregate U. As evidence, one can consider that since the s, the U. For example, the U.

However, the gains and losses in employment and production caused by the trade deficit will not be dispersed evenly across regions and sectors of the economy: on balance, some areas will gain while others will lose.

And by shifting the composition of U. Although the compositional shift in output has no negative effect on aggregate U. This is more likely to be a concern if the economy is already sluggish than if it is at full employment. Otherwise, it is likely that government macroeconomic policy adjustment and market forces can compensate for any decline of output in the trade sector by expanding other elements of aggregate demand. However, the study estimated that benefits to the U. In addition, the RMB appreciation would increase U.

Analysis by the IMF suggests that currency appreciation alone by China would yield limited benefits to the global economy including the U. Chinese officials argue that their currency policy is not meant to favor exports over imports, but instead to foster economic stability through currency stability. The policy reflects the government's goals of using exports as a way of providing jobs to Chinese workers and to attract FDI in order to gain access to technology and know-how.

The Chinese government has stated on a number of occasions that currency reform is a long-term goal which will be implemented gradually. Officials have strongly condemned international pressure to induce China to appreciate the currency, arguing that it interferes with China's "sovereignty" to implement its own domestic economic policies.

In , then Chinese Premier Wen Jiabao was reported by Chinese media as complaining that "some countries demand the yuan's appreciation, while practicing various trade protectionism against China. It's unfair and actually limits China's development. Despite the Chinese government's numerous pledges on currency reform, it has moved somewhat cautiously.

Chinese officials view economic growth as critical to sustaining political stability, and thus appear very reluctant to implement policies that might disrupt the economy and cause widespread unemployment, which could cause worker unrest. Instead, they contend, promoting rapid domestic growth is the most significant policy China can undertake to promote global economic recovery. They note that Chinese imports rose by They further note that export growth in and the first half of was significantly below historic rates see Figure In June , Xinhua claimed that the yuan was nearing equilibrium against the dollar.

Figure Change in China's Trade Flows: June Source: Global Trade Atlas using official Chinese statistics. Data for are annual changes. Data for January-June are year-on-year changes. Eliminating exchange rate risk through a managed peg also increases the attractiveness of China as a destination for foreign investment in export-oriented production facilities.

However, there are a number of potentially negative aspects to China's export growth strategy and currency policy. Although a rebalancing of China's economy, including the adoption of a market-based currency, would likely entail significant adjustment costs, it also would likely produce long-term benefits to the Chinese economy.

For example, it could:. The great challenge for Chinese leaders, assuming that they are committed to greater economic reform and rebalancing the economy, would be to quickly generate new sources of economic growth and job opportunities in order to offset the decline of those sectors that would no longer be able to compete once preferential government policies such as subsidies and an undervalued currency are eliminated.

However, some analysts contend that this rebalancing could prove difficult for China politically and could take several years to achieve. For example, according to Michael Pettis, reforming China's economic policies would have to involve political reforms because "eliminating the mechanisms by which Chinese policymakers can transfer income from households to manufacturers will reduce their control over the commanding heights of the economy, and it will sharply reduce the power and leverage the ruling party has over business and local governments.

If the Chinese were to allow their currency to float, it would be determined by private actors in the market based on the supply and demand for Chinese goods and assets relative to U. If the RMB appreciated as a result, this would boost U. At the same time, the Chinese central bank would no longer purchase U. This would reduce spending on interest-sensitive purchases, such as capital investment, housing residential investment , and consumer durables.

The reduction in investment spending would reduce the long-run size of the U. In the present context of a large U. If the relative demand for Chinese goods and assets were to fall at some point in the future, the floating exchange rate would depreciate, and the effects would be reversed. Floating exchange rates fluctuate in value frequently and significantly. A move to a floating exchange rate is typically accompanied by the elimination of capital controls that limit a country's private citizens from freely purchasing and selling foreign currency.

The Chinese government maintains capital controls and arguably one of the major reasons China opposes a floating exchange rate because it fears a large private capital outflow would result if such controls were removed. This might occur because Chinese citizens fear that their deposits in the potentially insolvent state banking system are unsafe. If the capital outflow were large enough, a banking crisis in China could result and could cause the floating exchange rate to depreciate rather than appreciate.

In other words, the United States would still borrow heavily from China, but it would now be private citizens buying U. China could attempt to float its exchange rate while maintaining its capital controls, at least temporarily. This solution would eliminate the possibility that the currency would depreciate because of a private capital outflow. While this would be unusual, it might be possible.

It would likely make it more difficult to impose effective capital controls, however, since the fluctuating currency would offer a much greater profit incentive for evasion. Another possibility is for China to maintain the status quo. Even without adjustment to the nominal exchange rate, over time the real rate would adjust as inflation rates in the two countries diverged. The Chinese central bank acquires foreign reserves by printing yuan to finance its trade surplus.

As the central bank exchanged newly printed yuan for U. This real exchange rate adjustment would only occur over time, however, and pressures on the U. None of the solutions guarantee that the bilateral trade deficit would be eliminated. China is a country with a high saving rate, and the United States is a country with a low saving rate; it is not surprising that their overall trade balances would be in surplus and deficit, respectively.

As the Appendix discusses, many economists believe that these trade imbalances will persist as long as underlying macroeconomic imbalances persist. At the bilateral level, it is not unusual for two countries to run persistently imbalanced trade, even with a floating exchange rate.