China’s decision to allow its currency to devalue by 2% on Tuesday (8/11/15) will certainly reignite the debate as to whether China manipulates its currency, primarily for the purpose of giving itself an advantage as an exporter. Below we review the main points that both sides of this question are likely to consider.
If you think China manipulates its currency unfairly, you are likely concentrating on the following factors:
Exports built on years of fixed exchange rates: For many years China’s exchange rate was firmly fixed. During that period China’s export grew tremendously, largely because China’s exchange rate didn’t appreciate as its economy grew.
Currency still not freely traded: China’s currency is more liberalized now, but is still not freely traded. The government limits how much the value of the currency can move in any given day and also intervenes directly in the market frequently.
Seems obvious China is trying to boost exports: China’s economy is struggling to maintain momentum, with the latest bad news being that exports fell in July by 8%. The devaluation in the RMB is clearly an attempt to spur exports which is what currency manipulation is intended to do.
If you think China does NOT manipulate its currency unfairly, you are likely concentrating on the following factors:
Substantial appreciation over the last decade: China’s currency has appreciated by more than 30% over the last ten years, which runs contrary to the notion of manipulating the currency to maintain an artificially low exchange rate.
Liberalized trading rules: The RMB is not completely freely traded, but it is much more freely traded than in the past. The exchange rate is allowed to move within a range on any given day, and that range has been gradually increased to plus or minus 2%. Plus there is now an offshore market for the RMB in Hong Kong that is completely unregulated by Beijing. Furthermore, in conjunction with the 2% devaluation, China announced new rules that should make it currency trading regime even more free-market oriented.
Export market share still strong: In addition to an appreciating currency, China has also experienced rapid wage inflation over the last 5-7 years, generally averaging double-digit growth every year. Yet, adjusted for slow global growth, China’s exports have remained strong. It has gained market share at the high end (electronics, telecom, appliances) and lost a relatively small amount of market share at the low end (shoes, clothing, toys, etc.). Meanwhile, manufacturing employment in the US has not increased dramatically since China’s currency appreciated. The implication is that China’s exports are strong because its wages are low because it is a relatively poor country and that the currency value played a relatively minor role over the years.
Due to capital flows and economic weakness, China has been supporting (not suppressing) the RMB: For many years, due to capital account restrictions, the RMB could not be held outside of China and Chinese people and companies could not invest outside of China. As a result, China’s exchange rate was impacted only by trade flows, not by capital flows and trade flows like more free-market oriented economies. China has been gradually loosening its capital controls. Plus, China’s economy has been slowing, which gives investors a reason to invest overseas. The result is that capital has been flowing out of capital which puts downward pressure on the RMB. Over the last six months or longer, China has actually been intervening in the market to support the RMB, not suppress its value. This runs contrary to the notion of manipulating the currency to drive exports.
The IMF says China’s currency is fairly valued: In May of this year the IMF announced that it no longer considers China’s currency to be undervalued, in large part due to the factors mentioned above.
If exchange rates are being manipulated, China isn’t the only one: One way to depreciate a currency is to increase the money supply and decrease interest rates. The US, Europe, and Japan have been pursuing a policy of extremely low interest rates ever since the global financial crisis of 2008. Although the stated goal of the central banks of all three countries or regions might not be exchange rate manipulation, in fact low-interest-rate policies have an impact on exchange rates. As evidence of this, over the past four quarters, although China’s currency has been relatively stable against the US dollar, as compared to a trade-weighted basket of currencies, it has risen by 13%, suggesting that China’s 2% devaluation is still well below what other nations have done for their currencies.
Conclusion: Manipulation requires more than one day
The bottom line is that a one day movement in the exchange rate cannot truly settle the question as to whether China is trying to manipulate its currency. Plus, a 2% change isn’t exactly earth-shattering. The big question is how will China address the currency market in the weeks and months ahead? Will market forces push China’s currency down further? If so, will China try to support the RMB? Or, if the market doesn’t push China’s currency lower, will China’s central bank try to achieve that objective anyway? Of course, no matter what China does, not everyone will agree as to whether it is manipulating its currency. But in three to six months we will certainly have more data upon which to base an opinion.