China's Strategy: Appreciating the Yuan

China's Currency Struggle

China's golden decade was marked by an undervalued yuan which brought huge benefits to its industrial sector as it was making Chinese products cheaper to foreign buyers. The country witnessed a large increase in exports which led to an unprecedented trade surplus.

Nevertheless, an undervalued currency has both its benefits and limitations. A cheaper yuan allows companies to sell goods for less to overseas consumers thus boosting exports at the expense of the Chinese population which would suffer from a reduction in buying power.

A more expensive yuan increases household purchasing power but has the effect of shrinking the country's exports and increasing its imports, thus reducing trade surplus. China finds itself in internal struggle over whether to appreciate its currency or not as either monetary policy has its pros and cons.

Officials from Western countries have been pushing China to strengthen its currency to allow the latter to invest more in the US and Europe as well as attracting wealthy Chinese consumers under the pretext that a stronger yuan would lead to sustainable growth for the global economy.

The yuan strengthened considerably during the years prior to the financial crisis due to the pressure exerted by the Bush Administration. This trend stopped after the economic recession of 2008 and reverted back only on June 2010 after signs of the global downturn had faded. The yuan has since gained over 10% over the dollar.

Is China deliberately appreciating its currency?

Why are the Chinese authorities deliberately allowing the Yuan to appreciate? There are three key reasons that justify the government's action on promoting such a policy:

  1. Reducing exposure to risk related to foreign securities
  2. Containing inflation
  3. Increasing acquisition of foreign resources

China's current portfolio of foreign securities includes over $1.2 trillion of US Treasury bonds and other foreign exchange reserves, worth a total of $3.3 trillion. This exposes China to two main factors, the devaluation of the U.S. dollar relative to other currencies and inflation in foreign countries.

A rising inflation in the U.S. would weaken the dollar thus reducing the purchasing value of Treasury bonds held by the Chinese Central Bank. Similarly, if the U.S. dollar looses ground over the Euro, China's buying power in Europe would decrease. Reducing the amount of foreign exchange reserves would reduce these risks, however, that is almost impossible due to the country's large current-account surplus.

Chinese authorities may also favor a stronger yuan to contain the country's inflation rate. By doing so, imported products would become cheaper to Chinese consumers and firms alike. Reducing import costs is advantageous to China as it imports an ever increasing amount of consumer goods, commodities and raw materials.

Due to the Federal Reserve's loosening monetary policy which was reaffirmed by the announcement of an open-ended round of quantitative easing, also known as QE3, China needs the yuan to rise in value so as to reduce the risk of holding large amounts of U.S. Treasury bonds.

China's Acquisition of World Resources

During the last decade, China has been expanding its acquisition of resources across the world. China's policy of cooperating with any government to help secure the resources has turned to its advantage, allowing it to acquire anything from oil fields to mines and land in every continent.

China's thirst for energy reserves and commodities is driven by its large population and growth of energy consumption. Demand for industrial commodities such as steel, copper and cement remains strong as the government keeps on pumping money into large infrastructure and construction projects.

China has also been acquiring vast amounts of gold, bringing the official gold reserves up to 1,000 tonnes and has become the number one producer of the precious metal, with an estimated yearly production of 300 tonnes.

The more interesting aspect of China's spending spree though is the acquisition of energy resources. The U.S. has maintained its status as the world's most powerful country because it controls a large portion of the world's oil production and global oil trade is traded for the most part in U.S. dollars.

However, the dollar's status as the world's reserve currency is being threatened as China has been acquiring vast energy resources worldwide and is planning on investing trillions of dollars over the next decade in alternative forms of energy. On top of all this, China has signed agreements with several countries to stop trading in dollars, while instead using their own currencies as well as gold.

The next big war between the big powers is going to be the Energy War, i.e. who is going to control the world's energy resources. China understands that whoever has control over global energy resources is going to come out as the leading economic power during the 21st century. We may see this policy building up at an even more accelerated pace after the Chinese elections in November.

Though several emerging market economies such as Brazil and South Korea have reduced interest rates as a way to ease their currency, China has eased ever so little. The country's short term interest rates are significantly higher than the average over the past 10 years. Furthermore, their foreign exchange reserves keep on increasing.

The current decade may bring about big changes in the economic field as Western economies struggle to recover and Asian markets emerge, establishing themselves as new financial powerhouses. It is entirely possible that we may even witness the U.S. dollar's demise as the world's reserve currency in the near future.

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Comments 2 comments

Estess profile image

Estess 4 years ago from London Author

Michael, glad it clarified a few points. I find that most articles rarely touch all the reasons why China appreciates the yuan and fail to see the bigger picture. Many readers still believe they are doing it purely due to pressure from the US and Europe and don't understand that China has an interest in doing so.

charmike4 profile image

charmike4 4 years ago from Adelaide, South Australia

Thanks for sharing this estess. I was reading this in the financial papers over the past couple of months and your articles gives some good perspective on this. it also clarifies a few points, so thanks. Cheers Michael

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