China is a chronic currency manipulator, in the sense that, like the great majority of the world's countries, the People's Bank of China (PBoC) intervenes regularly in foreign exchange markets to influence the exchange rate of the yuan. The US dollar, in contrast, is one of the few currencies whose exchange rate floats freely in response to supply and demand. The fact that China actively intervenes in forex markets while the US does not is a chronic source of friction.
The most visible manifestation of Chinese currency policy is the bilateral exchange rate of the yuan against the US dollar:
As the chart shows, until August 2005, the PBoC held the bilateral exchange rate fixed at a rate of 8.27 yuan per dollar. After that, it switched from a strictly fixed rate to a managed float, under which the yuan was allowed to appreciate, but generally less rapidly than market forces alone would have dictated. In 2008, in response to the global financial crisis, China briefly returned to a fixed rate regime. Then, in mid-2010, it resumed its managed float and has continued to lean against the wind, holding the yuan somewhat below the value that it would reach under a free float.
Looking just at the bilateral nominal exchange rate gives an incomplete picture of Chinese currency policy, however. For a broader picture, we can look at the real effective exchange rate (REER) of the yuan. The REER is a weighted average of a country's exchange rate relative to the exchange rates of all its trading partners, adjusted for differences in the rates of inflation in different countries.
As the next chart shows, China's REER appreciated strongly from the resumption of the managed float through 2015. During that period, it outperformed all of the major currencies of the Asia-Pacific region, including the dollar. In early 2016, the Chinese REER began to depreciate, although there has been a small uptick in recent months. Even after recent events, the yuan has appreciated more than the dollar over the past six years.
What currency movements alone do not show is the role that PBoC policy plays in these currency movements. Countries that manipulate the value of their currency, whether they maintain strictly fixed rates or a managed float, do so primarily by buying and selling foreign reserves. If a central bank wants its currency to depreciate, or to slow its rate of appreciation compared to what market forces alone would dictate, it buys foreign currency to add to its reserves. If it wants its currency to appreciate, or wants to slow its rate of depreciation, it sells foreign currency from its reserves.
The role of foreign exchange reserves in exchange rate management means that we can use movements in reserves as an accurate indicator of policy. The following chart shows the ups and downs of the Chinese currency reserves since 2010.
From the resumption of the managed float in to June 2014, reserves grew steadily. During this period, the PBoC was actively holding its exchange rate below the market equilibrium. Although the yuan was allowed to appreciate in nominal terms, the rate of appreciation was less than what would have resulted from market forces alone. After mid-2014, there is a dramatic change. Reserves began to fall steadily for the first time in recent history. From that time to the present, the PBoC has been spending tens of millions of dollars every month to slow the rate of depreciation of the yuan.
For the past two and a half years, then, the PBoC has been acting as the ally, not the enemy, of those in the US who want to keep the yuan strong. Of course, it has not done this out of concern for American interests, but for its own.
The Chinese government's main concern is to slow outflows of capital, which have accelerated in recent months. Those outflows are driven, in part, by fears about the stability of the Chinese domestic economy, including worries about mountains of debt, zombie industries, and the reemergence of a housing bubble. However, they are also driven by a vicious cycle in which depreciation makes investors all the more determined to get their yuan out of the country and reinvested abroad before the exchange rate falls even further.
Both Chinese and American policymakers will have to tread carefully to avoid destabilizing the situation. If warnings of a trade war become a reality, financial outflows could accelerate and Chinese officials could decide that it is simply too costly to resist further depreciation. That would be the worst possible scenario for those in both countries who fear the consequences of a weak yuan.
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