What free-trade aims to do is make the global market more efficient. Over the last few years, China has surged, and become the world’s #1 exporter yet its currency still remains devalued. Furthermore, it overtook Japan and became the world’s second largest economy. How does China keep its currency so undervalued? The United States accuses China of artificially devaluing their currency by printing money and increasing the yuan’s supply on the currency market. This affects many countries, such as the U.S., Japan and the Eurozone in a negative way. China used to have a fixed currency system which meant that the government fixed the value of Yuan to another currency or commodity, in this case the U.S. dollar . The fixed currency system requires a lot of government intervention. As of July 2005, China’s currency is determined by a managed currency system which can be defined as limits the government sets for how much a currency can appreciate (rise in value of a currency in a floating exchange rate system) or depreciate (decrease in value of a currency in a floating exchange rate) before the government intervenes on the foreign currency market. The U.S. finds the yuan’s “rigidity” a problem. The U.S. and China, the world’s largest economies, may be at the start of a trade-war which will not only be internecine to both economies, but also to other economies around the world.
The balance of payments is an account of a country’s financial transactions with the rest of the world. A section within the balance of payments is the current account, which measures the trade in goods and services and net investment income and transfers. A country can be in either a current account surplus or current account deficit. A current account surplus exists where the revenue from teh export of goods and services and income flows is greater than the expenditure on the import of goods and services and income flows over a given period of time. A current account deficit is just the opposite; it is where revenue from the export of goods and services and income flows is less than the expenditure on the import of goods and services and income flows over a given period of time. Currently, China is in a current account surplus and the U.S. is in a current account deficit. The Chinese surplus means that they are more likely to invest in the U.S. As we know, China has bought many U.S. treasury bonds. U.S. has a deficit to China, about $250 billion and it is the largest debt it has. This investment is good for the U.S. because they cannot invest in their own economy as they are running a deficit. The Chinese investment is helping the U.S. be more productive.
A country running a surplus would generally want an appreciating currency to decrease their surplus and reach 0. However, this is not the case with China as an appreciating currency means that people are more wealthier, and therefore will buy more imports, and it will be more expensive for exporters to sell their products to other countries. China wants to continue its economic growth and therefore do not want this appreciating currency. So, the government intervenes in the foreign exchange market to devalue (intentionally decrease the value) of their currency.
Figure 1 shows how the Chinese government can artificially depreciate its currency using its foreign currency reserves. By buying other currencies and thereby putting more yuan on the foreign currency market, the government can shift the supply curve from S1 to S2. We can see that the yuan is depreciating as the quantity increases from Q1 to Q2 but price decreases from P1 to P2. This means that Americans can now buy more yuan for 1$.
This is good for China because it means that their exports will be cheap and therefore they will be gaining more revenue. This is good for U.S. consumers as they will be able to import Chinese products for cheaper. However, this is bad for the U.S. businesses as people will be using their money to buy cheap exports instead of the domestically/inefficiently produced products. This could potentially lead to shutting down of U.S. businesses and an increase in unemployment and inflation. The Chinese have been accused of making the value of their currency lower than its actual worth to prevent inflation in their country.
Even if the U.S. $ is strong and this means that consumers can buy more of imports, it is bad for their exporting industries. If this continues, the U.S. will have a larger debt. If the Chinese government suddenly decides to allow the exchange rate to reflect the demand for its currency accurately, this may lead to high inflation and therefore a decrease in standard of living. If the Chinese government appreciates the yuan slowly, exporting industries and the citizens will have more time to adjust.
Overall, I do not think that the U.S. has the right to tell China how to work its currency. They are getting the largest investment from China. Without this investment, many U.S. businesses may not be able to survive through the current economic down turn as the U.S. itself is in a large debt. Besides, the U.S. has already put protectionist measures against China. If China slowly lets the yuan appreciate, this may make the economic terms world-wide better.