Many argue that on simple purchasing power parity, the Chinese currency the Renminbi is undervalued by approximately 30%. This is a source of friction in the US, with firms claiming they lose out to a cheap Chinese currency which can undercut US goods.
The Chinese government wish to keep the currency undervalued because:
- A weaker exchange rate makes exports more competitive and increases demand for Chinese exports.
- Chinese economic growth is dependent on exports, so the value of the currency plays a key role in boosting growth
- China needs high growth. China’s economic growth is remarkable high by global standards. But, because of the switch from a state controlled industry to free market economy, there is still a problem of unemployment. Growth in exporting manufacturing industries plays a key role in creating jobs that are being lost in agriculture and other privatised state owned industries. With little welfare support for the unemployed, the Chinese government are concerned about social unrest should unemployment rise in the overcrowded cities.
How The Chinese Currency is Kept Undervalued
Problems of Undervalued Currency
- Despite the benefits of a weak currency. It also has some problems for the Chinese economy.
- A weak currency creates inflationary pressure. A weak currency means commodity prices are more expensive. Since China is a big importer of commodities, a weaker exchange rate increases the cost of living and the cost of raw materials. The Government have allowed a small appreciation in the exchange rate to help mitigate inflationary pressure.
- China is seeking to divesify away from dollar assets. To maintain a weak exchange rate, the Chinese need to keep buying dollar assets. However, many are worried about holding so much dollar assets given weakness of US economy. Therefore, China is seeking to diversify away from US dollar, but, by doing this the exchange rate will appreciate.
- Criticism from US. I doubt China give too much importance to complaints from US politicians, but, at the same time they can’t afford to completely ignore the biggest purchaser of Chinese goods. It is in the interest of China to have a strong US economy.