How and why China devalues its currency?

I am sure all of you have heard US President Donald Trump accuse China of manipulating China’s currency. He claims that China devalues its currency in order to stay competitive. Let’s break that down and see how and why China devalues its currency.

Before we dive into detail, we must first understand what globalization is. So, what is globalization? According to Merriam Webster, globalization is the development of an increasingly integrated global economy marked especially by free trade, free flow of capital, and the tapping of cheaper foreign labor markets. Globalization is the reason why you see so many products that are “Made in China”.  It’s due to globalization why the clothes that are made in China are cheaper than those made in the United States. Globalization is why factories move offshore. Globalization gives you exposure to “cheap labor”, which directly translates to “cheap products”. Due to globalization, Apple can set up manufacturing factories in China, and Cisco can outsource its IT services to India. In short, the world got a lot smaller due to globalization.

This is great news for China since it now has a competitive advantage (cheap labor, low prices), and a huge market that will buy cheap products. After all who wants to overpay? So, what does China do to ensure that it doesn’t lose this competitive advantage? It devalues its currency. What does that mean? Devaluation is the decrease in value of one currency in relation to another. How and why does China devalue its currency?

Everything comes down to how supply and demand affect price. For example, when US companies buy Chinese steel, they have to pay those Chinese steel manufacturing companies. Since CNY is the local currency of China, US companies convert USD to CNY. In other words, to pay for that Chinese steel, US companies get rid of their USD (increase in supply) and need more of CNY (increase in demand). Since there is an increase in supply of USD (left graph below), the price of USD decreases. Consequently, the increase in the demand for CNY (right graph below) will push the price of CNY higher. So, CNY will gain strength against USD i.e. when you visit China and convert your USD to CNY, your dollar is going to get you less CNY.

supplydemand

Now, an export based / manufacturing economy like China would hate to see its currency appreciate in value. Why? Because if CNY increases in value, then the products won’t be “cheap” anymore. Let me give you an example. Assume that 100kg of steel costs 5000 CNY, and the foreign exchange rate is 1 USD = 5 CNY (hypothetical). This means that 100kg of steel is going to cost you 1000 USD. However, due to the increased demand for CNY (talked about this in the previous paragraph), the foreign exchange rate now shows that 1 USD = 2 CNY. So, all of a sudden, 100kg of steel is going to cost you 2500 USD. As you can see the price of steel more than doubled when CNY appreciated in value against USD. Hope this example gives you an idea why China would want to devalue its currency. An increase in the value of CNY makes products more expensive, and less appealing to importers. In order to stay competitive with companies around the world, China has to make sure it has the cheapest products.

So, how does China ensure that products stay “cheap”? By devaluing its currency! China devalues its currency by buying US government debt i.e. by buying US government bonds. How does that devalue China’s currency? (Hint: take a close look at that left graph above) Going back to supply and demand affecting price. In order to buy US government bonds, China has to convert CNY into USD i.e. China has to get rid of CNY (increase in supply) and get more of USD (increase in demand). By increasing the demand of USD, China ensures that USD stays strong i.e price of USD stays high. Consequently, increasing the supply of CNY devalues the price of the China’s currency. In short, when China buys US government bonds, CNY loses value and USD gain value (think supply demand and price). This is exactly how China devalues its currency. 

Let’s recap. China devalues its currency in order to stay competitive i.e. to keep its products “cheap”. China devalues its currency by buying US government bonds. Now, what would happen if China didn’t devalue its currency? Do you think manufacturing would possibly return to the United States if there was a true equilibrium in the currency market? Is US President Trump correct in accusing China for manipulating its currency? The bigger question I have is who would fund the US government if China stopped buying US government bonds?

Note: all currencies in the world are inter related. I am using an isolated scenario of USD and CNY.

american and chinese flags and usa dollars
Photo by Karolina Grabowska on Pexels.com

Hope you learned a little and found this blog post helpful. We talked about globalization, devaluation, supply and demand affect currency price, and how China manipulates its currency to stay competitive. As always, you can sign up for our mailing list here.  Like us on our Facebook page here. Thank you!


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