Readers question: Nor do I understand how they can weaken their currency through government intervention, if they are not intervening. Is it only US that is complaining about the value of the Yuan?
The main thing is that Chinese Central Banks, with the support of the Chinese government are purchasing foreign assets, such as US Treasury Bills. This purchase of US assets increases the value of the dollar and prevents the Chinese currency appreciating.
If China didn’t buy all these US Treasuries, there would be a larger supply of dollars on the foreign exchange market, reducing the value of dollar.
In a way China is lending the US money to finance its government debt, though that isn’t the main motivation.
The value of Chinese foreign asset purchases often closely resembles their current account surplus. The current account surplus is the amount that the value of exports exceeds the value of imports.
The Chinese began accumulating foreign currency reserves in 1980s, but, this process rapidly accelerated in recent years leaving them with the world’s biggest foreign currency reserves of $2.6 trillion. The majority of these holdings have been in dollars. According to the China Securities Journal, an official Chinese newspaper about 65% of these holdings are in dollars.(Economist link)
However, this year, China has been starting to diversify away from the dollar. Japan are now worried about Chinese purchases (¥2.3 trillion ($25.5 billion) in the first seven months of this year). This has helped drive up the Japanese Yen (something the Japanese don’t really want given the state of their economy.)
However, at the moment China only pegs its currency against the dollar and not a wider basket of currencies.
The irony of Chinese Reserves
The US has a large public sector debt. In one way you would expect US to be grateful China is so willing to buy US Treasuries. This enables the US to finance its budget deficit at low-interest rates. (Though in a liquidity trap, some commentators make the point, the US should be able to have no problem selling US treasuries, even without China)
However, the US complains that because China is buying so much US Treasuries, the dollar is overvalued against the Yuan reducing exports.
There is another irony that because China has so many dollar assets, they now have a vested interest in the value of the dollar. If there was a sharp fall in the dollar, they would see a decline in the value of their foreign assets. This is perhaps why the Chinese are increasingly diversifying away from buying dollar assets but are also purchasing more Japanese assets. (Perhaps China could be persuaded to buy Greek and Irish bonds 🙂 )
What Would Happen if China Sold All Its Reserves?
Some fear that, because of its large currency reserves, China has power over the US and other countries. If China sold part of its dollar reserves we would see:
- Appreciation in Yuan
- Depreciation in Dollar
- Interest rates on US Treasury bills would increase
- A decline in Chinese Current account surplus. A decline in Chinese exports and lower growth.
This depreciation would probably help the US economy grow, the Chinese export sector would be hard hit, leading to potential unemployment and social unrest.