Dollar and Yuan: Two Versions of China’s Monetary Policy

Dollar and Yuan: Two Versions of China’s Monetary Policy

There is much that is paradoxical and contradictory in the monetary policies of the world’s two biggest economies – the US and China. The US, for example, accuses China of devaluing the yuan and thereby artificially stimulating its exports. America is unhappy when Beijing plays at devaluing its currency, as well as when China props it up, or at least keeps it afloat. 

In the same way, China is unhappy, both because Washington has for several years pursued a policy of quantitative easing that weakens the US dollar and strengthens the yuan against that US currency, and also because Washington has reined in its program of quantitative easing and is preparing to raise the Fed’s discount rate for the first time in years. The first example undermines the position of Chinese exporters focused on the US market. The second threatens to drain a great deal of capital out of China. 

Washington’s and Beijing’s paradoxical «monetary dualism» can be attributed to the fact that both states are trying to use their monetary policies to accomplish conflicting goals. They want to secure an advantageous position for their exporters’ goods on global markets, while at the same time carving out a strong position in the international capital market. They need to devalue their currencies to achieve the first goal, but must strengthen them in order to achieve the second. 

Washington has long pursued a strong dollar policy, otherwise the global dollar system would have collapsed long ago. Washington’s outraged claims that China is pursuing a policy of currency devaluation («currency dumping») are for the most part politically motivated. This is a traditional, reliable method by which the US puts pressure on Beijing. Washington is far more frightened by Beijing’s policy of propping up the yuan. That policy would undermine the global dollar system that the US spent the entire twentieth century putting together.

The US could take a tactical approach and try to temporarily strengthen other currencies. One memorable example of that was the famous Plaza Accord of 1985, when Washington convinced Tokyo to allow the exchange rate for the yen to rise. This increase proved fatal for Japan: exports from the Land of the Rising Sun began to decline, which dealt a blow to that country’s entire economy. The Plaza Accord was the kiss of death for what had been known as the Japanese economic miracle. The yen, which in the 1970s was still seen as a rival to the dollar, entered an irrevocable decline. Uncle Sam magnanimously allowed the yen to retain its reserve currency status, leaving it in the IMF’s «currency basket». It is now reminiscent of an educational museum exhibit. 

Looking at China, the «currency dualism» in Beijing’s policy is not an optical illusion, as is the case in Washington. 

For several decades China has been expanding its exports, capturing global markets and becoming the top exporter in the world today. Thanks to exports, China is now the world’s leading economic power, if that country’s gross domestic product is evaluated in terms of the purchasing power parity of the yuan vs. the US dollar. Several factors have contributed to what has been called the Chinese economic miracle: low labor costs, most-favored-nation trading status with the US and other Western countries (which is prompted by the West’s geopolitical plans for China), and the devalued Chinese currency. 

We are interested in the last of these factors. 

At its lowest point between 1981 and 2014, the yuan had depreciated by nearly three-quarters (72.3%), but began to climb again more than 20 years ago. Washington itself unwittingly contributed to the strengthening of the yuan. During the financial crisis, the US Federal Reserve and Treasury infused huge numbers of dollars into the banking system, which contributed to the depreciation of the dollar. After the financial crisis, the Americans initiated a program of quantitative easing, which continued to weaken the greenback. 

Over the last year, China’s monetary agencies have begun to take an active role in supporting the yuan. Early last year the US Federal Reserve began hinting that the quantitative easing program in the US would be phased out. That was a signal that the era of the weakened dollar was ending and that it will soon begin to strengthen. Even before that signal, global capital could be seen making a U-turn and rushing back into the US, moving from the periphery of world capitalism toward America. This had a direct impact on China. According to estimates made by the US Treasury, $500 billion in capital drained out of China in the first eight months of this year. 

All this came at a bad time for Beijing, which over the last year has tenaciously fought for the yuan to be granted the status of an official reserve currency. To this end, China’s monetary agencies had been actively engaged in currency intervention for well over a year, generously devoting their international reserves to that goal. In the summer of 2014 China famously set a world record – $4 trillion – for the accumulation of such reserves. And then Beijing began to burn its way through it. The latest figures (from the end of October 2015) show that China’s international reserves have fallen to $3.5 trillion. In a little over a year China has burned through half a trillion dollars. This was a very risky game, as the costs could not be recouped. But luckily for Beijing, on the last day of November, the IMF’s Executive Board finally decided to include the yuan in the fund’s basket of reserve currencies.

I think it is possible that the Chinese economy could see some temporary positive benefit from the yuan’s new status as a reserve currency. Some investors will probably invest in yuan-based assets in order to diversify the currencies in their investment portfolios. But very few investors are likely to move entirely into yuan. 

China now has a mass of problems that converting the yuan into a reserve currency will not solve. First of all, the Chinese stock market still suffers from bubbles. Second, various sectors of the economy are deeply in debt. Third, there is an enormous shadow banking sector. Fourth, labor costs in China are rising. Plus, there is the expected increase in the Fed’s interest rate, which will only accelerate the flight of capital out of China. 

China will soon have to sort out its monetary policy. This is a subject under discussion in the country, and two main strategies can be discerned. 

Supporters of one course of action insist on continuing the current policy of suppressing China’s strengthening currency, which will encourage the Chinese economy to develop on the back of increased exports. 

Proponents of the other strategy want to prop up the yuan, turning it into an international currency and gradually transitioning from international trade to international capital transactions. Both conceptual approaches have their weaknesses. 

However, there is also a group of politicians and economists in China who propose a third option for solving the country’s financial and economic problems. They can tentatively be called the «orthodox communists», who focus on the economic progress made during the first decade of the PRC’s existence, as well as the economic history of the Soviet Union. On monetary and financial issues, they advocate a complete ban on any foreign capital entering China’s banking sector, a halt to the free cross-border movement of capital, the establishment of a state monopoly on foreign exchange, the restriction of the yuan to use only as domestic legal tender, and the establishment of a fixed exchange rate for the yuan.

Tags: IMF  China  US