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Published on February 3rd, 2012 | by Saira Khan
Image © [caption id="" align="alignleft" width="311" caption="ddonar ©"][/caption] We all know the basic economic principle that when supply is greater than demand, prices will fall. A floating exchange rate corrects the effects of trade imbalances by allowing the value of a currency to rise or fall in order to restore some equilibrium in foreign exchange markets. For example, if the US were to import $50 million of goods (expressed in yuan) from China and to export $20 million of their own goods, there is a disequilibrium which can be ‘corrected’ by movements in the exchange rate. What the US is supplying (its $20 million exports) is of lower value than what it is demanding (the $50 million imports). The value of the dollar will weaken and the yuan will strengthen. In relation to a stronger Chinese currency, the price of the US goods would decrease for Chinese importers; fewer yuan would be needed to buy the same amount of US goods. This means that they are cheaper from the Chinese standpoint and the demand for them should increase, meaning the amount exported from the US would increase above the original amount of $20 million. The Chinese goods bought by the US would increase in price as the dollar is devalued; i.e. to make up the same value of yuan, more dollars are needed. This increased import price will decrease demand for Chinese goods and the original $50 million import expenditure should be lowered. Thus the previous more-imports-than-exports situation will be rectified of its own accord. Market forces restore equilibrium via the independent operation of the floating exchange rate. But this is not what always happens. Instead, China manipulates the exchange rate; it creates ‘false’ demand for US dollars by buying them, keeping the dollar strong, and keeps its own currency weak by printing yuan. Alternatively, it can flood the foreign exchange markets with yuan, increasing its supply and thereby reducing its market price i.e. its exchange rate. It purposely seeks to maintain this trade imbalance. But why would it want to do this? If China allowed its currency to strengthen – and other currencies to weaken in respect to it – importing Chinese goods would become more expensive, as seen in the $50 million US imports example above. This would make their demand fall and fewer Chinese goods would be bought. China needs to maintain its monopoly on goods by keeping their demand high. The way to do this is to make its goods cheap with a weaker currency. The side effect is inflation – a weaker currency means more yuan is needed to buy the same products internally; prices will increase for the Chinese consumers -- although attempts to correct this are made through increasing interest rates. Extra Chinese money is invested in the US Government in Treasury bonds. China then gets interest on its money in financing the US debt. But how can this work to China’s advantage if the US is in such deep debt? There is, of course, the scenario that if the US defaults, China effectively owns the country. But if it does not, China’s aim is to create demand for Treasury bonds, increasing their price and consequently reducing the interest that needs to be paid back on this debt. This also makes loans within the US easier to attain and reduces borrowing costs. If the debt is cheaper for the US, they will consume more, therefore buying more Chinese goods.

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Currency appreciation? Don’t make me yuan.

ddonar ©

We all know the basic economic principle that when supply is greater than demand, prices will fall. A floating exchange rate corrects the effects of trade imbalances by allowing the value of a currency to rise or fall in order to restore some equilibrium in foreign exchange markets. For example, if the US were to import $50 million of goods (expressed in yuan) from China and to export $20 million of their own goods, there is a disequilibrium which can be ‘corrected’ by movements in the exchange rate. What the US is supplying (its $20 million exports) is of lower value than what it is demanding (the $50 million imports).

The value of the dollar will weaken and the yuan will strengthen. In relation to a stronger Chinese currency, the price of the US goods would decrease for Chinese importers; fewer yuan would be needed to buy the same amount of US goods. This means that they are cheaper from the Chinese standpoint and the demand for them should increase, meaning the amount exported from the US would increase above the original amount of $20 million. The Chinese goods bought by the US would increase in price as the dollar is devalued; i.e. to make up the same value of yuan, more dollars are needed. This increased import price will decrease demand for Chinese goods and the original $50 million import expenditure should be lowered. Thus the previous more-imports-than-exports situation will be rectified of its own accord. Market forces restore equilibrium via the independent operation of the floating exchange rate.

But this is not what always happens. Instead, China manipulates the exchange rate; it creates ‘false’ demand for US dollars by buying them, keeping the dollar strong, and keeps its own currency weak by printing yuan. Alternatively, it can flood the foreign exchange markets with yuan, increasing its supply and thereby reducing its market price i.e. its exchange rate. It purposely seeks to maintain this trade imbalance. But why would it want to do this?

If China allowed its currency to strengthen – and other currencies to weaken in respect to it – importing Chinese goods would become more expensive, as seen in the $50 million US imports example above. This would make their demand fall and fewer Chinese goods would be bought. China needs to maintain its monopoly on goods by keeping their demand high. The way to do this is to make its goods cheap with a weaker currency. The side effect is inflation – a weaker currency means more yuan is needed to buy the same products internally; prices will increase for the Chinese consumers — although attempts to correct this are made through increasing interest rates.

Extra Chinese money is invested in the US Government in Treasury bonds. China then gets interest on its money in financing the US debt. But how can this work to China’s advantage if the US is in such deep debt? There is, of course, the scenario that if the US defaults, China effectively owns the country. But if it does not, China’s aim is to create demand for Treasury bonds, increasing their price and consequently reducing the interest that needs to be paid back on this debt. This also makes loans within the US easier to attain and reduces borrowing costs. If the debt is cheaper for the US, they will consume more, therefore buying more Chinese goods.

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