Back in 2008, U.S. Democratic Presidential nominee Senator Barack Obama (D-IL) had severely criticized China for “…manipulation of its currency’s value...”. The future POTUS blamed such acts of currency manipulation as the main cause of China’s massive trade deficit with the US.
During the 2012 presidential debates, candidate-hopeful Mitt Romney too pledged to brand China as a currency manipulator – if he got to the Oval Office. But in 2012, President Obama declined to name China a currency manipulator. And then there’s candidate Trump who, on the 2016 campaign trail, vowed that he would declare China a currency manipulator on day one of his administration. But later, POTUS Trump declined to name China as a currency manipulator.
The current US-China trade negotiations have once again renewed the focus on China’s currency policy. It is therefore expected that, as part of a China-US trade agreement, currency will focus front and center. The big question on everyone’s mind is: Who will benefit from a currency deal – the US or China?
Two sides of a currency story
In the past, China has consistently been hoarding USD, and buying other USD-denominated investments, in order to shore up its forex reserves and drive down the value of its currency. Chinese exporters to the US typically receive payments in USD. They forward those dollars to the People’s Bank of China (PBOC) in lieu of yuan payments.
The PBOC then stockpiles its horde of USD, sharply reducing the supply of the greenback in the world. The law of supply and demand then takes over. Reduced supply of USD for trade puts upward pressure on its price. This then results in a lowering in the value of the yuan. When China’s RMB falls (becomes “cheaper”), in relation to the USD, that helps to make their export trade more lucrative.
But there’s another side of that story as well!
A sharply rising RMB, however, is unpalatable to the Chinese government, because its exports suffer (become more expensive). The PBOC then strategically manipulates the value of the RMB to suit its own economic needs. We saw a classic example of this in 2015, when China re-engineered its monetary policy to allow its currency rate to be determined by market forces. This saw the yuan fall by over 2% - to 6.23 yuan per USD.
So, how did China’s central bank “restore” the yuan? The PBOC sold over $1 trillion USD from its sizable forex reserves to buy back its own currency to prop it up in the face of sharp downward pressures from global market forces. Again, supply-demand came into play. More dollars in global circulation lowered the value of the US currency. Less yuan supply (thanks to PBOC’s aggressive buying spree!) pushed its value higher viz. the greenback. By mid-august the yuan was trading at 6.39 per USD.
This proves that China has the willingness and ability to play both sides of the currency story. A currency deal with China will therefore need to be woven into the broader context of a balanced trade deal. Otherwise, currency leverage could still overwhelmingly favor China. A case in point:
The USD rose by more than 25% between 2014 and 2016. Since the yuan was tied (pegged) to USD, its trajectory mirrored the greenback, making Chinese export goods more expensive than those of its competitors who had not pegged their currencies to the USD. To remain competitive, the Chinese government had to lower the yuan-USD exchange rate. So, when the dollar started drifting lower towards the end of the year, the PBOC simply stayed put, allowing the yuan to rise.
Misplaced deal priorities
There’s no doubt that China has been a currency manipulator in the past, strategically buying USDs and Treasury paper to depress the value of its own currency. As a result, the Chinese have been largely successful in artificially creating a lower Yuan – something that has enabled them to steeply increase their export of cheaper-valued goods to the US (and the rest of the world). This has come at great consternation to US manufacturers.
Despite Trump’s imposition of tariffs on over $250 billion worth of Chinese imports, the US deficit with China has continued to rise (as is evident from the data table presented below). As of the last reported figures for 2018, that deficit rose to a record-breaking $419 billion – and is still climbing. So, it would only make sense that any deal should prioritize the reduction of that deficit. But how to achieve that objective is really at the heart of the question: Will the US benefit from a currency deal with China?
The US Treasury department closely monitors for any signs that China is using currency manipulation as a tactic to depress the value of its currency. If China (or any other country) spends an equivalent of around 2% of its annual economic output on the purchase of USD, in the hopes of driving the US currency up and pushing the yuan down, China will be branded a currency manipulator and must immediately be placed on the Treasury department’s blacklist.
Never has any US government actually designated China a currency manipulator – not since July 1994, when Bill Clinton’s Treasury Department branded China with that label. But as the table of data from the US Census Bureau shows, that did nothing to actually slow down the deficit.
In fact, there is no evidence that the US trade deficit is the result of currency wars. So, trying to address the trade deficit through a currency deal, or with the threat of labeling China a currency manipulator (again!) is misplaced and could backfire!
The Real Deal
Previously, the US has expressed concerns over China’s “buy USD” policy to prop its currency. However, signals are now emerging that a currency deal with China could simply mean China agrees to not let the yuan depreciate – which would be meaningless. Alternately, the currency deal may simply formalize a commitment for both sides to merely “consult” with each other in the event either side proactively steps in and intervenes in the currency market.
As we’ve seen from previous analysis above, that still leaves plenty of “currency levers” that the PBOC can pull to influence the balance of trade.
The bottom line is this: The broader focus of the ongoing Sino-US trade talks is to attempt to bring down the sizable trade deficit between the two countries. Any “real deal” to achieve that central objective must therefore focus on core issues, such as both countries’ fundamental economic conditions. Structural issues, including competitive demand and supply dynamics, forced transfer of technology, free and fair movement of goods and services, and government subsidies dished out to state-owned organizations should be the focus of a “real deal”.
However, instead, if the major focus of any proposed deal ends up in merely orchestrating an “engineered” deficit balancing act using a currency side-deal, then the US stands to lose – big time. Such a deal will not be a “real deal!”. Armed with a massive chest of over $3 trillion in forex reserves, the Chinese would be more than willing to solemnly pledge not to let the RMB fall against the US dollar. That’s one commitment they’ll readily make if it means other trade imperatives - IP theft, industrial espionage and commercial cyber spying – go largely unchecked in any new deal.