Why China's Currency Tangos With The USD

China's economic rise in the modern world began with a reformist leader in the early 1980s named Deng Xiaoping. By introducing policies that opened China to trade and economic relations with the outside world, Xiaoping led China on a quasi-capitalist venture that would continue for 30 years.

One of the ways China's economic rise was accomplished was by pegging its currency, the Chinese yuan (also known as the renminbi) to the United States dollar and instituting trading arrangements between the two nations. China's trade with the U.S. began in 1985 with imports to the U.S. totaling almost $4 million, according to the U.S. Census Bureau. This number has grown each year since that time. In 2008, imports from China totaled $337.8 billion. 

SEE: Global Trade And The Currency Market

How Pegging a Currency Affects an Economy
From 1985 to 2008, U.S. exports to China have been equivalent to about one-third of China's exports to the U.S. So the Chinese peg to the dollar has been quite beneficial for China's exporting businesses. In addition, pegging the yuan to the dollar made investors much more confident in China's currency. Without the peg, China's economic rise would have been much slower because the yuan was nearly worthless compared to all of the leading economic nations of the world. 

In particular, the Chinese accomplished its fast economic rise by pegging its yuan to the dollar at a very low rate. China does not price its currency based on interest rates because interest rates are not a monetary tool used by the Chinese, unlike other leading nations. Instead, China prices its currency based on Chinese banks' reserve requirements. Rather than appreciating or depreciating the yuan based on an interest rate, or allowing the yuan to float freely on the open market, the Chinese hold their currency price steady based on a fixed exchange rate regime. Increasing reserve requirements serves to reduce the amount of currency in the economy and decreasing requirements increases the amount of money available for use. 

SEE: Currency Exchange: Floating Rate Vs. Fixed Rate

The Yuan/Dollar Relationship
One of the arguments against a yuan/dollar relationship is that it appears that China benefits more than the U.S. Manufacturers in the U.S. often put pressure on Congress to lobby China to appreciate its currency, citing the difficulty of competing against artificially cheap Chinese goods as a reason for change. Year after year, new bills are introduced by Congress demanding that China appreciate its currency so the yuan/dollar balance is more equalized. They claim the Chinese are protecting their trade superiority and the U.S. is forced to pay the price.

The problem from China's perspective is that appreciating the yuan could mean less foreign investment in China, deflation, lower wages and unemployment. Fewer exports will also diminish China's supply of dollars for investment, both inside and outside the country. China argues that the currency peg is meant to foster economic stability and abandoning the peg could result in an economic crisis.

When Undervalued Is a Good Thing
Some benefits of an undervalued yuan for the U.S. include lower prices for consumers, lower inflationary pressure and lower input prices for U.S. manufactures that use Chinese inputs. Alternatively, an undervalued yuan hurts U.S. industries that compete with cheap Chinese goods, thus hurting production and employment in the U.S. Also, a low yuan makes U.S. exports more expensive to Chinese consumers and reduces exports to China.

As of 2009, the yuan/dollar mid-point was pegged at 6.8339. This means that one U.S. dollar = 6.8339 Chinese yuan. As with any commodity, if the demand for yuan increases or decreases, the central bank has to respond accordingly by supplying or removing currency from the markets to restore equilibrium and maintain the peg. The Chinese central bank will buy or sell either dollars or yuan to maintain the desired balance.

Usually, central banks will buy or sell their own currency to maintain the peg, as it is actually U.S. dollars that the Chinese wish to accumulate through balance of trade with the U.S. Appreciating the yuan means that the Chinese would accumulate less in foreign reserve dollars and disrupt the economic stability that they have grown accustomed to since they began trading with the U.S. and the outside world. 

SEE: What Is The Balance Of Payments?

The Bottom Line
China finds itself in a unique situation. Calls for China to appreciate its currency places the country in a no-win situation with trading partners due to fear of inflation at home and the possibility of earning less in foreign reserves. Yet the yuan/dollar peg must be maintained for both sides due to the abundance of trade each side maintains.