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China’s Devaluation Game: A Highly Political Exchange Rate Policy

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By: Declan Walker

 

The yuan depreciated in value by 1.9% on August 11th, and then again by 1% on August 12th, marking the biggest two-day drop in value against the dollar in over 20 years. Consequently, the devaluation was met with intense scrutiny by the international economic community. But are China’s motives really as rapacious as many believe? Although the recent discussions surrounding the devaluation of the yuan are most likely to pertain to the turmoil surrounding its stock market, the reality is that the impact of China’s exchange rate policy is not confined purely to the sphere of economics, and other views which have equally profound implications are worth exploring. In order to attain a proficient understanding of the contemporary ‘currency wars’, and China’s impetus for engaging in them, it is first useful to provide a brief analysis of the Chinese political economy. What many fail to realize is that China’s ardent policy of maintaining a low yuan may be every bit a political move as it is an economic one. To many, China’s devaluation of the yuan is nothing more than a means to ‘one-up’ the United States by driving up its trade deficit. Indeed, while China undeniably gains economically from these maneuvers by staying on the right side of an enormous trade imbalance, the issues regarding the devaluation run far deeper.

 

Political Economy of China

A critical analysis of the contemporary Chinese political economy reveals that China’s exchange rate policy is equally important to its internal social policy as it is to its economic platform. The unparalleled and enormous upward trajectory which has characterized the Chinese economy in the past twenty years did not come about without substantial social reforms. Indeed, one of the most significant of these changes came at the expense of the Chinese welfare state. Up until 1979, China’s welfare system provided its 970 million citizens with food and a skeleton-network of social services. This meant that the government was sinking billions of dollars worth of subsidies into state-owned companies which oversaw the distribution of these services. However, during this period, the Chinese economy was characterized by stagnant growth rates and overall inefficiencies in its state-run enterprises. Consequently, China reduced its welfare programs on a massive scale, allocating the money instead towards infrastructure and modernization initiatives, in addition to investing heavily in its export sector. Although the right steps were being taken to oversee the implementation of a quasi-market economy, one which would undoubtedly boost Chinese GDP, the Chinese welfare system was reduced to almost nothing. In order to maintain social stability, the government had to offer the public some type of compensation in place of a greatly diminished social security net: the promise of constant job creation. This agreement remains the definitive stabilizing element in the relationship between the Chinese state and its 1.4 billion citizens today. In this respect, job growth is crucial to the continuity of the Communist Party. David T.C. Lie, Chairman and CEO of the Newpower Group- one of the largest trading, investment, and consultancy firms in China- has explicitly stated that the Communist Party’s greatest fear currently is not the United States, but dissent amongst migrant workers facing unemployment, and their potential to mobilize politically. It is indispensable to understand that China’s gravest threat resides not in Washington, but within her own borders. The social discourse which culminated in the Tiananmen Square protests of 1989 are testament to the existence of China’s inherent volatility and its potential to manifest into crisis. The Communist Party is acutely aware of this reality and as such, this variable is taken into consideration in every policy implementation- including economic policy.

The relationship between currency policy and social stability can be seen in the following brief analysis:

  1. China maintains a devalued yuan. The low value of the yuan means that Chinese exports are substantially cheaper compared to those of its competitors, which generates foreign demand for Chinese products and increases foreign direct investment.
  2. Cheap exports in combination with cheap labour allows China to build up a huge trade surplus, and it accumulates massive foreign currency reserves through this vast surplus. Estimates of its foreign currency reserves are thought to be well over $3 trillion, with at least a third of all reserves thought to be in US dollars and dollar-denominated assets (primarily in the form of US Treasury Bills).
  3. China uses its currency reserves to fund its infrastructure investment projects and further develop its export sector, which subsequently ensures almost perpetual job growth.
  4. If job growth can be sustained on a steady upward trajectory, social stability is effectively maintained in China.

 

The Dollar and the Yuan: Two Sides of the Same Coin

US monetary policy plays a paramount role in China’s own economic policy, and by extension, also impacts its domestic platforms. This is because the yuan is firmly pegged to the dollar at a fixed exchange rate, so any movement in the value of dollar, whether it be a devaluation or an appreciation, will inevitably alter the real value of the yuan. In light of the Fed’s policy of quantitative easing, or QE, employed after the 2008 crisis, it is worth examining the effects that US inflation (and its encompassing depreciative affect on the dollar) will have on the Chinese economy.  

The monetary transactions which take place between US and Chinese firms are useful in illustrating this. Consider the following: Since the yuan is pegged to the dollar, the People’s Bank of China (PBOC) absorbs virtually all dollars that flow into the Chinese economy. For example, if a Chinese firm receives X number of US dollars for its latest shipment of goods, it must then trade these dollars for Y yuan at whatever rate (relative to the dollar) that the currency is currently fixed at. So it must be established here that the PBOC is buying dollars with yuan. This is where quantitative easing becomes relevant. QE, as a monetary policy, involves the US Federal Reserve increasing the money supply by printing more money, which puts inflationary pressure on the price level, and results in a depreciation in the value of the dollar. If QE is then factored into this direct trade-off, this means that more dollars (which are lower in real value) flow into China. In response, the PBOC must purchase all the excess dollars with yuan and as a result, the exporting firms will subsequently receive less yuan for the dollars that they exchange, equating to a reduction in the net-export component of China’s GDP. Furthermore, since the yuan is pegged to the dollar, and around one-third of its currency reserves are in US dollars or dollar denominated assets, once the PBOC adds this new accumulation of dollars to its reserves, the real value of its entire foreign currency reserves is now worth less, relative to the yuan (i.e. one US dollar will now be worth less yuan). A slight movement of the dollar can prove to have profound consequences in China: if all Chinese-held US dollars and dollar-denominated assets amounted to $1 trillion, a 2% devaluation of the dollar brought about by QE would deplete the real value of China’s currencies reserves by $20 billion. In other words, the PBOC is effectively purchasing American inflation, and as a result the yuan has now appreciated in value relative to the US dollar (it should be realized that the yuan’s appreciation and the $20 billion loss in real wealth are the same effect). As such, the costs of Chinese infrastructure investments are now more expensive in real terms. Furthermore, this will decrease foreign direct investment in China, particularly in the realm of exports, which are now more expensive in real terms as well. More imperatively, however, in the bigger picture this means that job growth has taken a hit, which as aforementioned, is a crucial factor for stability in China. So in order to maintain the real value of its foreign currency reserves, China opts to devalue to the yuan against the dollar, adjusting the exchange rate to a level at which it sees as the point of equilibrium necessary to sustain the perpetual (albeit artificial) growth rate of the economy.

 

A Politicized Policy

To the extent that fluctuations in the exchange rate can greatly affect the economic mechanisms which play a crucial role in maintaining perpetual job growth in China, it is apparent that China’s exchange rate policy is a manifestation of its contemporary social and political environment. While the economic consequences are indeed the most visibly and immediately felt on the surface, the detriments of dollar devaluation to China prove to run deeper today, with the potential to impact its social and political paradigms. In this regard, the importance of Beijing’s exchange rate policy becomes evident. Suffice it to say, China is certainly not an innocent player in the currency war, and it has undoubtedly engaged in malicious devaluations of the yuan with the aim of gaining economically at the expense of its trading partners. However, its role is much less predatory than many think, especially in the face of a tenacious anti-deflationary monetary policy which is continuously favoured by the Fed. As such, the rationale for employing aggressive currency tactics can at least be partially linked to a pragmatic effort on the part of the Chinese state to maintain social and political stability within its borders.

 

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