Why is Chinese Currency Undervalued?

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

The Chinese Central Bank purchases large quantities of dollar assets, such as US Treasury Bills. This demand for dollars, increases the value of the dollar compared to the Chinese Yuan.
(If the Chinese sold its dollar assets and saved the money in China, the dollar would depreciate and the Chinese currency appreciate)

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.

12 thoughts on “Why is Chinese Currency Undervalued?

  1. The standard of your commentaries has risen in recent months: I’ve found them more difficult to criticise than six months ago! However there is a flaw in the above commentary.

    You claim “Chinese growth is dependent on exports” (2nd bullet point). You then argue that a lot of labour is quitting agriculture and state industries. Plus this labour needs jobs, therefore an undervalued currency and a healthy export sector is helpful in creating such jobs.

    I suggest an artificially under or over-valued currency is very hard to justify. Instead of boosting employment via exports, China can perfectly well boost employment by boosting internal demand (which is exactly what they have done recently in view of the drop in demand for their exports caused by the credit crunch). The resulting deterioration in their balance of payments shouldn’t be problem in view of their huge balance of payments surplus.

    I suggest the above mistake of yours is a classic example of what is sometimes known in economics as targeting “intermediate objectives”. That is, the fundamental objective in economics is maximising income per hour worked (within environmental constraints). Making “employment” or “the balance of payments” an objective, nearly always results in lower incomes for citizens than could be the case. Indeed, under the policy I suggest above, the Chinese would spend more time making stuff for internal consumption rather than for consumption by foreigners, which ought to boost Chinese incomes.

  2. I believe that they have not much choice as they are entering a developed market and without a undervalue currency they would not be able to break in.

  3. The chinese are in a very difficult position and they would try to keep the currency low but there’s no way to do so forever. It will go up.

  4. Terms of art? Exactly what is undervalued currency. Please define the term and explain the dynamic so we know what you are talking about

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