Why Is China Trying to Hold Down the Value of the Yuan? What Evidence Suggests That China Is Indeed Pursing a Weak Currently Policy?

1. Why is China trying to hold down the value of the yuan? What evidence suggests that China is indeed pursing a weak currently policy?

China is trying to hold down the value of the yuan because the Chinese government worries that a large body of unemployed people would lead to unrest. China believes that it needs to export in order to keep people employed and provide jobs, as state enterprises become obsolete and close down. It is obvious that China is pursuing a weak yuan policy and it is shown by the Chinese Central Bank in the peg to the dollar being maintained despite the weakening of the dollar. The fixed exchange rate and the large quantity of dollars the government is buying up to support the dollar against the yuan are the evidence of the peg, as seen in recent years in the jump in China’s foreign exchange reserves where China’s Central Bank adopted a managed float where it simply sells the yuan and buys vast amounts of dollar reserves.

1. What benefits does China expect to realize from a weak currency policy?

China expects to benefit from a weak currency policy boosting economic growth. China hopes to absorb newly unemployed people from state enterprises that are being shut down with the flourishing of export businesses. In addition, it encourages Chinese trading partners to further grow. Also, by expanding the yuan money supply in pursuit of this policy and maintaining a weak yuan (which raises the price of the foreign goods) a perceived potential deflation can be averted.

3.        Other things being equal, what would a 27.5% tariff cost American consumers annually on $200 billion in imports from China?

Other things being equal, American consumers would be paying an additional $55 billion annually for the $200 billion of Chinese products the US imports if a tariff cost of 27.5% would be imposed. (0.275 x $200 billion). This would allow domestic products to compete with its Chinese counterparts but could also spark a trading war.

4.        Currently, imports from China account for about 10% of total U.S. imports. A 25% appreciation of the yuan would be the equivalent of what percent dollar depreciation? How significant would such a depreciation likely be in terms of stemming America’s appetite for foreign goods?

If a 25% appreciation is imposed by the yuan, it would lead to a dollar depreciation meaning that the dollar cost of Chinese goods would rise by the same percent. Exactly, the yuan appreciating 25% would increase the dollar cost of the United States imports by about 2.5% overall with Chinese imports accounting for about 10% of the total United States imports. With the Chinese products being more expensive it would create domestic products being more competitive and the appetite for the Chinese goods dropping in favour of domestic products due to the currency exchange.

5.        What policy tools is China using to maintain the yuan at an artificially low level? Are there any potential problems with using this policy tool? What might China do to counter these problems? 

To maintain the yuan at an artificially low level, the Central Bank of China is selling yuan and buying up all the foreign currency inflows. However, maintaining the weak value creates a potential danger of inflation in the long term due to the rising money supply because of the low rates of the yuan. The inflation pressure in China can be noticed through the prices of assets. In order to fight the issue of inflation and the asset price bubbles, the Chinese government will be forced to raise the interest rates as the government sells more bonds, driving down bond prices. In addition, the Chinese government could sterilize its foreign exchange intervention but it could result in more pressure on the yuan to appreciate. Lastly, as suggested in the next answer, China could let its currency grow so that the capital outflows could appreciate. This is why China will have to let their currency to appreciate at some point.

1. Does an undervalued yuan impose any cost on the Chinese economy? If so, what are they?

Yes, an undervalued yuan raises the cost of foreign goods and services to Chinese consumers and companies. It also reduces their purchasing power overseas. Chinese consumers must pay higher prices for foreign goods making it more difficult for Chinese businesses and investors to expand into foreign markets. Also, another cost on the Chinese economy from an undervalued yuan is the possibility of stirring up protectionist measures in its trading partners. On the other hand, if they revalue the yuan, the Chinese government would be in a better situation dealing with domestic inflation and asset bubbles.

1. Suppose the Chinese government were to cease its foreign exchange market intervention and the yuan climbed to five to the dollar. What would be the percentage gain to investors who measure their returns in dollars?

There would be a rise of the yuan from 0.1208 (from 1 divided by 8.28) to 0.20 (1/5). We would take the difference of the new value and the old and then divide it by the value of the old, which equals to a growth of 65.6%.

8.        Currently the yuan is not a convertible currency, meaning that Chinese individuals are not permitted to exchange their yuan for dollars to invest abroad. Moreover, companies operating in China must convert all their foreign exchange earnings into yuan. Suppose China were to relax these currency controls and restraints on capital outflows. What would happen to the pressure on the yuan to revalue? Explain.