Yesterday we focused on China’s monetary policy and how China’s central bank, the People’s Bank of China (PBOC), differs from other major central banks like the US Federal Reserve system. Today we’ll focus on how China uses global trade to tightly control the value of its currency. For decades one of the primary mandates of the PBOC has been to artificially devalue the Yuan to spur export-led growth in China.
The PBOC tightly controls the Yuan's value within a narrow trading band, which is the main difference between the Yuan and floating currencies like the US Dollar. When someone refers to a currency like the US dollar or the Euro as “floating currencies,” what they mean is the value of the dollar of the Euro fluctuates based on the principles of supply and demand in international foreign exchange (FX) markets.
The market forces driving the value of floating currencies are complex, but when the value of a floating currency like the US dollar rises in relation to another currency, it reflects higher demand for dollars.
China’s Yuan has never existed as a fully free-floating currency. From roughly 1950 until the 1990s, market forces did not have any influence on the Yuan’s value. Its price was “fixed” based on the objectives set by the central planners of China’s rigid Marxist-Leninist economic system. In the late 1970s and 1980s, China gradually liberalized its monetary policy beginning with Deng Xiaoping’s economic ‘reform and opening up’ period (改革开放).
After years of trial and error, China ultimately settled on a hybrid system where the Yuan is effectively pegged to the US dollar. The main thing to consider is no one knows the market value of the Yuan because it hasn’t ever been able to float freely. To understand why this matters, we need to explore the concept of the capital account and why China’s capital account is unique.
As a mechanism of international trade, the concept of balance of payments is essential. every country has a current account and a capital account. “The current and capital accounts represent two halves of a nation's balance of payments. The current account represents a country's net income over a period of time, while the capital account records the net change of assets and liabilities during a particular year.”
In a perfect world, trade between countries would balance out equally. Country A would export goods of X value to country B (imports), and country B would export different goods of equal value back to country A. Perfect balance.
The real world doesn’t work this way. Global trade and capital flows are not equally balanced and what ends up happening is some countries export more than they import and vice versa. Countries that import more than they export (like the United States) run what’s called a trade deficit. Countries that export more than they import (like China) run a trade surplus.
This same logic applies to capital flows and balance of payments as well. As is true with trade, countries with capital inflows exceeding capital outflows (like Germany) have a balance of payments surplus. Conversely, countries where capital outflows exceed capital inflows run a balance of payments deficit.
Like Germany, China runs a balance of payments surplus, which on its own isn’t unusual. However, the difference between Germany and China is that Germany’s capital account is wide open while China’s capital account is closed. In countries with an open capital account, international capital flows in and out of the country without restrictions.
In China’s case, monetary authorities severely restrict capital outflows so China can build up an artificial balance of payments surplus. In other words, the amount of foreign money entering China always exceeds the amount of foreign money leaving China. This means China can build up a massive stockpile of foreign exchange (FX) reserves. In China’s case, think of FX reserves as a massive (3 trillion US dollar) pile of cash China’s State Council through the State Administration of Foreign Exchange (SAFE) can use to do whatever it wants.
This is the mechanism China uses to control the Yuan's value, and we’ll uncover the global implications of this dynamic in future notes.
How China uses trade to its advantage (recap):
China’s trade surplus creates its balance of payments surplus
China’s balance of payments surplus creates its stockpile of foreign exchange reserves (3 trillion US Dollars)
China uses its FX reserves to buy and sell its own currency (the Yuan) internally, which gives Chinese authorities control over the value of the yuan