Why is the Chinese Yuan Pegged?

Posted on March 8, 2016 by Anthony Jerdine

Why Is the Chinese Yuan Pegged?
By Anthony Jerdine|Updated March 08, 2016

The Chinese yuan has had a currency peg for years. This approach makes Chinese exports cheaper and, therefore, more attractive relative to those of other nations. By providing the global marketplace with greater motivation to buy its goods, China can help ensure its economic prosperity.

As long as a currency peg keeps the yuan low relative to other currencies, consumers using foreign currencies can buy more of China’s exports than they would if the yuan was more expensive. For example, if the People’s Bank of China keeps the yuan weak compared to the U.S. dollar, consumers using the greenback can buy more Chinese exports than they would otherwise.

Exports are a major driver of any economy, as they represent money flowing into a nation. To keep the yuan artificially low and support robust export activity, the People’s Bank of China engages in currency purchases. As a result, the central bank’s foreign exchange reserves (minus gold) surged from roughly $600 billion in December 2004 to $3.8 trillion in December 2014.

Economic Boom
This currency manipulation has helped China thrive, as the nation’s economy has repeatedly experienced robust growth rates of more than 10% over the last decade. China’s industrial sector has done particularly well, as it became the world’s largest manufacturer in 2011, according to a McKinsey report.

This first-place status has signaled a significant increase compared to its seventh-place status as recently as 1980, the report adds. Because of this robust growth, China doubled its gross domestic product (GDP) per capita over the course of a decade, a feat that the industrialized United Kingdom completed over a stretch of 150 years.

This rapid expansion has helped China grab a 23.2% share of global value-added manufacturing as of 2013, according to U.N. estimates reported on by Manufacturers Alliance for Productivity and Innovation.

Costs and Benefits
While these facts and figures may sound great for China, not everyone is optimistic about the situation. U.S. manufacturers and workers have complained about the Chinese trade surplus, claiming that the yuan peg has granted Chinese companies an unfair advantage, according to a Congressional Research Service report. As a result, U.S. lawmakers have called for revaluing China’s currency.

While opponents of yuan pegging have complained, they may be providing an overly simplified portrayal of the situation. An artificially low yuan is not without its benefits. The currency peg means cheap Chinese goods for U.S. consumers, a development that can help keep overall inflation at a modest level.

The benefits of these less expensive goods also extend to businesses. U.S. companies that use less expensive imported items from China to make goods can enjoy reduced costs of production. By lowering these expenses, such firms can either lower the prices for consumers or increase their profitabilities, or both.

Chinese trade deficits also provide a boon to the broader economy, as they necessitate the movement of capital to the United States from China, the Congressional Research Service report noted. If this foreign capital goes toward purchasing interest-bearing securities, such as U.S. Treasurys, this development would help to place downward pressure on borrowing costs and encourage stronger investments. In addition, lower interest rates are considered to support economic growth.

The Bottom Line
Pegging the yuan is a strategic policy move that provides crucial benefits to the Chinese economy. Using this approach, the People’s Bank of China can make Chinese exports more appealing on the global marketplace and help fuel greater prosperity for China. While many governments harness expansionary policies in the hope that they will generate the intended results, China has proved the efficacy of its currency peg over many years.

Chinese Yuan Pegged?