Why is value of Yuan so important?

Summary – impact of devaluation in Yuan

  • If the Yuan falls in value, Chinese exports will become cheaper compared to other countries (e.g. US, India, EU) A falling Yuan will increase demand for Chinese goods contributing to higher growth in China.
  • However, a fall in the Yuan will make US and Indian goods relatively more expensive and will lead to lower demand for US and Indian goods. This could lead to lower growth and unemployment in US/India. It will also cause a deterioration in the trade balance between US and China – and lead to a bigger current account deficit

Summary impact of appreciation in Yuan

  • An appreciation in the Yuan will make Chinese exports less competitive. The Chinese economy is reliant on the export sector and so the Chinese government worry that an appreciation in the Yuan could lead to lower growth, unemployment and social unrest.

appreciation-in-yuan

Significance of the Yuan in global trading

In recent decades the Chinese economy has grown very rapidly making it the world’s largest exporter. In 2018, Chinese exports accounted for 13.4% of global exports, compared to the 2nd largest exporter the US on 9.0% of global exports. (1)

The value of the Yuan has a significant impact on the price of Chinese exports and the relative competitiveness of other countries.

More detail on the effects of changes in the Yuan

Between 2005 the Yuan appreciated against the dollar. In 2005, one US dollar was worth 8.2 Yuan. By 2013, one dollar was worth only 6 Yuan.

If a Chinese good cost 100 Yuan.

  • In 2005, it would cost an American 100/8.2 = $12.20
  • In 2013, the same good would cost an American 100/6 = $16.67

This means that at the end of this period an American consumer would need more dollars to buy Chinese goods, and this would lead to a fall in US imports from China.

Effect of a devaluation in the Yuan

From 2015, China sought to devalue the Yuan. The impact of this devaluation is many.

devaluation-in-yuan

  • Chinese goods become cheaper. Increase in demand for Chinese goods. This helps to boost Chinese economic growth and maintain jobs in the Chinese manufacturing sector.
  • Rising dollar. The depreciation in the Yuan increased the value of the dollar. A rising dollar increases the purchasing power of American households; for Americans, imports become relatively cheaper and it can lead to a rise in import spending
  • Fall in US exports. The problem with a rising dollar is that US goods become relatively more expensive and this can lead to lower demand, and put manufacturing jobs at risk.
  • Widening of US trade deficit. An appreciation in the dollar will tend to cause fewer exports and more imports, and therefore, there is a larger current account deficit.

us-current-account-1960-17

The appreciation of the Yuan from 2005 to 2013 saw a reduction in the US current account deficit from 5.5% of GDP to 2%. A devaluation of the Yuan, ceteris paribus would cause a deterioration in the current account deficit. However, it is worth bearing in mind many factors affect the US current account deficit apart from just exchange rates. In 2019, the US current account deficit was 2.3% of GDP down from 2.4% in 2018.

Increased capital flows to US. The other side of the trade deficit is capital flows. To devalue the Yuan, the Chinese state banks will sell Yuan and buy dollar assets, such as US treasury bonds. This causes a devaluation in the Yuan, but also causes a credit on the US financial/capital account. Some economists argue a trade deficit is not a problem if it is financed by capital flows to buy it. The Chinese purchase of US assets helps to reduce interest rates on US bonds.

Lower US inflation. One impact of a fall in the Yuan is that it can cause lower inflation. With the dollar appreciating this puts downward pressure on prices for three reasons.

  1. Imports are cheaper – goods imported from abroad will have lower prices, directly reducing CPI.
  2. Relative fall in US aggregate demand. With slower exports and a rise in imports, domestic demand will fall causing lower demand-pull inflation.
  3. In the long-term, US firms may respond to appreciation by seeking to cut cost, become more efficient and remain competitive.

Depends on the elasticity of demand

One important evaluation is that the impact of a devaluation in the Yuan depends on the elasticity of demand for exports and imports. If demand is price elastic, then a fall in the price of Chinese goods will cause a relatively bigger percentage rise. If demand is inelastic, there will only be a small fall in demand. Many Chinese exports – clothes, electronics are relatively price elastic, so demand is quite price sensitive.

However, many sectors of US exports are quite priced inelastic. Apple phones, films, tv shows, high-end electronics – these are goods which are quite insensitive to a higher price. Therefore, an appreciation in the dollar is not necessarily a damaging event to US exporters. Struggling manufacturers who are losing long-term competitiveness may lose out, but exporters who have strong product will not be adversely affected by appreciation.

When US politicians blame the Chinese currency for problems in US manufacturing, it is only a part of the issue. An appreciation can highlight long-term issues in US exporters.

Effect on India

Another emerging economy affected by value of the Yuan is India. When the Yuan devalues and dollar appreciates, this will tend to cause a fall in the value of the Rupee, as Indians seek to buy dollars. In 2015, the value of the Rupee fell 5%. On the one hand, the depreciation should help Indian exporters, however, their main competitor for manufacturing exports is China so the price improvement is limited. Also, the Indian economy is at risk of inflation and a depreciation in the Rupee will cause further inflationary pressures. Also, with a weaker Yuan, Chinese exporters can sell goods cheaply to India, undercutting domestic Indian producers.

Market fundamentals driving the Yuan

Changes in the value of the Yuan have a significant effect on the Chinese and US economy. But, also it is worth remembering that the long-term value of the Chinese currency is driven by the underlying strength of the Chinese economy. The long-term appreciation in the Yuan from 2005 to 2015 was a sign of the growing strength of the Chinese economy and its long-term growth rate. Since 2015, the Yuan’s appreciation has been reversed and this reflects weaker prospects for China’s continued growth and its desire to become less export oriented.

Structure of the economy

A long-term change in the value of Yuan will also influence the structure of the Chinese and US economy. When the Yuan is devaluing and under-valued, it promotes Chinese export industry. An appreciation in the Yuan can start to shift resources from the export sector to domestic consumption. If we

Political effects of the Yuan

On 5 August 2019, the Trump administration officially name China a ‘currency manipulator’ – They argued China was artificially keeping the value of the Yuan below its market level to give Chinese industry an ‘unfair’ advantage and take jobs away from the US economy. A managed devaluation in the Yuan appears to give credence to this view that the Chinese government is setting the value of its currency for domestic advantage.

However, China claims they are merely trying to reflect changing market fundamentals and point to their slowing economy as the reason for depreciation. Economists such as Paul Krugman argue China was manipulating its currency in early 201-s (when the US had large trade deficit) but, in recent years, it is not

“China *was* a currency manipulator back in 2010-11. But at this point if anything it’s keeping the renminbi artificially high.” – Paul Krugman August 2019.

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