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The Overview

China's currency policies and utilization of fiscal mechanisms to artificially deflate the yuan (NYSEARCA:RMB) have been subject to scrutiny by its major trading partners, especially the United States, for years now. In fact, last October, tensions boiled over when the U.S. Senate passed a bill, on a 79-19 bipartisan vote, that encouraged the enacting of tariffs on countries with undervalued currencies. This has led to fears of a potential currency/trade war with China, but so far much of the heated rhetoric on both sides haven't been translated into solid execution. However, this by no means has mitigated the intensity of the excoriations. Even Ben Bernanke, the chairman of the Federal Reserve, has accused China's devaluation tactics of delaying a global recovery from the Great Recession and U.S. politicians have rained down criticism on China's "predatory" currency practices.

Deflation of the yuan has allowed China's exports to sell cheaper in host countries relative to the hosts' domestic products. This allows Chinese goods a competitive advantage in the area of affordability, an attractive advantage which has lured consumers in these times of economic hardship. Moreover, the inexpensiveness of Chinese products and labor has attracted billions of dollars to China in terms of foreign direct investment: in 2009, the total amount of FDI used in China topped $90 billion, and the total accumulated amount of FDI used in China from 1979 to 2007 is $943 billion. Huge conglomerates such as Wal-Mart depend on Chinese labor and Chinese suppliers to keep their products cheap, while corporations such as Apple depend on Chinese labor and Chinese suppliers to keep their profit margins wide. In fact, over 60% of Chinese exports are produced by foreign-invested enterprises producing in China, a phenomenon which has been made possible, in large part, by the weakness of the yuan.

The Change

China, as a communist country, has the ability to control its currency to an extent that is unparalleled by the other G8 countries of the world. However, despite China's stringent control of its currency and frequent rhetoric from the U.S. and other countries lambasting China's "currency manipulation," China has started to subtly shift its yuan policy and the yuan has started to grow stronger. Some analysts point out this is due to the success of increasing pressure piled on China to appreciate its currency. However, the true catalyst behind the strength of the currency is due to the Chinese government's loosening of controls on the yuan, which it views as necessary to achieve its ultimate goal: to make the yuan the dominant mode of currency that replaces the U.S. dollar as the international reserve currency. Recently the Chinese central bank allowed the yuan to reach a record high on April 27, while in mid-April, Chinese officials pledged in a five-year plan running through 2015 to keep loosening controls on currency flows. The objective of the five-year plan is to eventually transform the yuan into a convertible currency, one which can be readily bought or sold without government restrictions. Moreover, Chinese regulators recently raised quotas for foreigners buying onshore stocks and bonds to $80 billion from $30 billion, increased the amount of yuan held offshore that can be invested locally, and lifted a 6.5 year ban on locals holding long positions on the yuan. On April 14, China also widened the trading band for the yuan to 1% from 0.5%, which allows the yuan increased flexibility to fluctuate and is considered a major step toward paving the way for the yuan to eventually float freely.

The shifting policies of the Chinese government have strengthened the yuan relative to most other currencies. This strength is apparent when the performance of China's yuan is analyzed compared to the currencies of its top 6 import/export partners: the EU, USA, Japan, ASEAN, Hong Kong, and South Korea. We can expect the euro, the U.S. dollar, the Japanese yen, the Hong Kong dollar, and the South Korea won to most accurately reflect the impact of China's currency policies (for the sake of comparison ASEAN is excluded because it has no universally accepted currency). From a 1-year time span, the yuan has increased 14.13% against the euro, 2.89% against the US dollar, 2.16% against the yen, 8.94% against the South Korean won, and 2.81% against the Hong Kong dollar. Much of the gains may not seem extraordinary, but they are significant considering the tight control the Chinese government exerts over the yuan performance.

The Analysis

As the Chinese government seeks asset its power on the global stage, it is faced with a growing conundrum. If it continues its policy of containing the yuan at artificially low levels, China will keep its competitive export advantage, albeit at the cost of an inability to cement the yuan's status as a reserve currency. If China decides to embark on the path to ultimately turn the yuan into a convertible currency, China will most likely be able to expand its hegemony, albeit at the cost of losing much of its competitive export advantage and a further risk of slowing down its cooling economy. It will be interesting to see how China will balance the two alternatives in order to ensure continuing growth.

It will be in the best interests of China, at least in the short-term, to focus on maintaining the status quo of manipulating its currency to ensure it continues its export advantage. This is because, for now, the maintaining of significant growth in China's economy should be its number one priority. The Chinese government is currently in the midst of a huge transition of power in the Communist party, and there have been numerous cases, such as the brazen escape of Chen Guangcheng and the scandal surrounding Bo Xilai, of significant civil unrest. The last development the Chinese government needs is a slowing economy. This is because the opiate of the Chinese masses is economic prosperity; as long as standards of living continue to grow, the majority of the Chinese population will accept the forsaking of some basic human rights. Yet, China's economy is showing signs of sputtering. In fact, it may be on track to grow at its slowest pace in a decade and recent economic data, such as growth in industrial output, were much lower than economists expected. Thus, in order to ensure continued economic prosperity to appease its populace, it is in the best interests of the Chinese government to utilize every mechanism in its repertoire, including keeping its currency artificially low.

Source: The Evolution Of Yuan Policy