Since he took office, President Trump has greatly toned down his campaign rhetoric calling China a “currency manipulator.” He gave his reason for the shift in a tweet on April 16, 2017: “Why would I call China a currency manipulator when they are working with us on the North Korean problem? We will see what happens!”
Since then, North Korea conducted four more missile tests, so the North Korea problem isn’t improved, and China’s central bank has quietly intervened in the currency market—not by making the yuan weaker but by making it stronger. As a matter of fact, the yuan recently surged to its highest level against the U.S. dollar in six months. China’s central bank’s move to make the yuan stronger seems to contradict the traditional belief that China has been intentionally making its currency weaker to gain advantages in its export sector. So what gives?
Before I explain what China is trying to accomplish by making the yuan stronger, here’s a quick lesson on how China sets its exchange rate. Unlike the U.S. dollar, the yuan is not a free-floating currency. From 1994 to July 2005, China pegged the yuan to the U.S. dollar at a fixed rate, which many believe didn’t reflect the yuan’s true value. In July 2005, partially due to international pressure but mainly due to China’s increasing desire to make the yuan an international reserve currency, China announced it shifted from a fixed exchange rate to a “managed float.”
Here’s how it works: Chinese yuan is no longer pegged to the U.S. dollar. China’s central bank, People’s Bank of China (PBoC), sets the daily yuan’s central reference rate based on the weighted value of a basket of currencies. Domestically, the yuan is allowed to trade above or below the central reference rate within a narrow band preset by PBoC. Today that band is at 2 percent, which means PBoC caps the yuan’s daily up and down movement within 2 percent of its official reference rate.
This Is Just Better-Hidden Manipulation
China points to such currency reform as evidence that the yuan’s exchange rate has become more market-driven. But the truth is that China has never given up on keeping the yuan’s exchange rate under its firm control. Its manipulation has only become more discrete. Investors in the currency market refer to China’s currency mechanism as a “dirty float” because of the PBoC’s lack of independence.
Like all other government agencies in China, PBoC answers to the demands of the Communist Party leadership, who set the general direction for economic and currency policies. Thus, PBoC would adjust the yuan’s exchange rate not based on market direction, but whenever the party leadership deemed it necessary. For example, in 2008, China unofficially pegged the yuan against dollars rather than its stated basket currencies as a defensive mechanism to protect China from the global economic crisis.
From the fixed rate in 1990s to the “dirty float” in the 2000s, China’s currency manipulation focused on suppressing the yuan’s appreciation and keeping the yuan’s value artificially low to boost its exports. This strategy worked wonders for China. According to The New York Times, “By 2007, China’s broad trade surplus hit 10 percent of its gross domestic product — an unheard-of imbalance for an economy this large. And its surplus with the United States amounted to a full third of the American deficit with the world.” By the end of 2014, China built an impressive foreign reserve of $4 trillion.
A Cheaper Yuan Isn’t Always Better
However, even China learned that when it comes to exchange rate, lower isn’t always better. In 2016 PBoC overplayed its hand, which resulted the yuan plunging 6.6 percent against the U.S. dollar and reaching its lowest point since 2008.
Investors who were concerned about a slowdown in the Chinese economy and uncertain about China’s policy on the yuan began to sell yuan-dominated assets, which only accelerated the yuan’s depreciation. The prospect of the U.S. Federal Reserve’s potential rate hike also strengthened the U.S. dollar against the yuan. While currency depreciation does benefit exports, China recognized that such a low rate accelerated capital outflow from China.
According to Bloomberg, an estimated $1.2 trillion in capital fled out of China from August 2015 to December 2016. To stop the outflow, China took a series of actions to make the yuan stronger. In addition to selling more than $800 billion out of its reserve, China also implemented a series of capital control measures, including publicly shaming individuals and firms who moved capital overseas.
What really put the Chinese government on edge, however, was after Moody downgraded the credit rating of China’s sovereign debt and warned about China’s worsening debt situation on May 24 of this year. The yuan promptly dropped lower on the same day. China worries the downgrade will not only hamper China’s effort to attract capital inflow and stop capital outflow, but also might create instability for its leadership transition later this year. Naturally, China took the downgrade as a politically motivated insult. Chinese government officials called Moody’s move “inappropriate” and “invalid” and concluded that “some international agencies lack the necessary knowledge of China’s laws and regulations.”
Our Political Goals Trump Investor Stability
China now believes a stronger yuan matches China’s global prestige. Behind the scenes, PBoC took some drastic measures to pump up the yuan. The PBoC tweaked the mechanism in calculating its daily reference exchange rate, which resulted in” lessening transparency and the role of market forces in its calculation,” and made it harder for investors to make yuan-related investment decisions.
In addition, PBoC implemented a so-called “liquidity squeeze” against currency investors by instructing Chinese banks in Hong Kong to refrain from lending yuan. Such a liquidity squeeze increased the borrowing cost of the yuan, crashing investors who attempted to bet against a weakened yuan. All these PBoC maneuvers resulted in the yuan rising to its highest level against the U.S. dollar in six months. PBoC didn’t publicly acknowledge any role it played to pump up the yuan , but all investors saw the writing on the wall.
Some in the West point to China’s effort to make the yuan stronger against the dollar as evidence that China is marching toward an eventual “clean” float of the yuan. That’s wishful thinking. China will never give up full control of its exchange rate and using it to serve whatever economic and political purposes the communist government deems necessary. China’s recent intervention to make the yuan stronger again only further proves that China doesn’t hesitate to spend its ample resources to defend its currency policy at the expense of investors.
What China failed to realize is that such manipulation erodes the investors’ confidence, both domestically and abroad. Not surprisingly, Chinese people and businesses still found many sneaky ways to move capital out of China. Whether President Trump calls China a currency manipulator or not, foreign investors should be extremely careful and take all risks into account before investing in China or Chinese currency.