Impact of China Fixing the USD / Cny Exchange Rate

¶ … Markets

USD/CNY Currency Exchange Relationship

The amount of money passing through a foreign exchange market was pegged at $4.0 trillion per day in April 2010 (Bank for International Settlements, 2010). Among the many currencies traded on the open market, the U.S. dollar (USD) continued to lead the pack by a wide margin; a full 84.9% of all trades involved the USD. By comparison, the Chinese currency (CNY) increased its share of the global FX market from 0.1 to 0.9% between April of 20004 and 2010. To better understand how trade with China impacts the exchange rate this essay will examine monetary policy for both countries.

USD/CNY Foreign Exchange Market

The sum of the current (CA) and capital (CAP) accounts will theoretically be zero if the exchange rate between two currencies is flexible (MacDonald, 2007, p. 7). Since M = R + D, where M. is the base money supply, R is the reserves (CA + CAP), and D. The domestic credit issued by the central bank, then a flexible exchange rate theoretically permits monetary policy to function independently of foreign currency exchange rates. This is the case in the United States, but not in China (ECR Research, 2014). The central bank of China, the People's Bank of China (PBoC), controls the value of the yuan (renminbi) by pegging it to the most commonly traded currency, the USD. This practice of pegging the exchange rate keeps the currency value low, thereby increasing attractiveness of Chinese goods and services internationally and providing stability for importers and exporters.

A pegged CNY exchange rate, however, precludes PBoC from keeping CA and CAP independent of monetary policy (ECR Research, 2014). China has become a major economic force in the global economy, with a current account balance of 2.4% of GDP in 2014 (The World Bank, 2014). The bulk of this surplus is due to trade exports, although China continues to receive returns on foreign investments and income in the form of foreign aid. Since there continues to be a strong demand for Chinese goods and services, the amount of yuan exchanged for foreign currency remains high (ECR Research, 2014). This places a strong upward pressure on the value of the yuan, so the PBoC must purchase U.S. dollars and Treasuries to maintain a favorable exchange rate. This is problematic because the yield on these instruments is typically low and the amount of yuan being dumped on the open market increases the domestic money supply and inflationary pressures.

Figure 1

. USD/CNY balance of payments. Between 2005 and 2010 the USD/CNY exchange rate increased from about 0.124 to almost 0.147 dollars per yuan (Figure 1). This increase correlated with a sizeable increase in the volume of dollars flowing into the international currency markets (compare FX0 to FX1), due to U.S. consumers purchasing yuan to buy Chinese goods and services. The increased demand for yuan increased its value, so it cost more dollars to purchase yuan in the foreign exchanges (compare P0 to P1).

What is not reflected in Figure 1 is the impact the global recession had on the volume of trade between China and the U.S. Between 2005 and 2007, the importation of goods from China into the United States increased from $243 to over $321 billion, but between 2008 and 2009, during the Great Recession, the volume of Chinese imports decreased slightly from $338 to $296 billion (U.S. Census Bureau, 2014). By 2010, however, trade with China had begun to recover and reached $365 billion by year's end. The U.S. trade deficit with China also increased from $202 to $273 billion for the same five-year period. This data seems to reveal the Great Recession had only a modest impact on trade with China, probably due to Figure 2

. Historical data for CYB. Share price (top panel) and share volume (bottom panel) are shown.favorable pricing of Chinese goods compared to U.S. goods.

American investors can purchase and hold yuan by buying shares of the Wisdom Tree Dreyfus Chinese Yuan Fund (CYB) on the American Stock Exchange (Wisdom Tree, 2011). The inception date for this ETF fund was May 14, 2008, so it does capture foreign exchange market volatility at the onset of the Great Recession (Figure 2; ETF Database, 2014). Although PBoC lifted the peg in 2005, it was reinstituted at the end of 2008 during the global financial crisis. The goal of the fund is to provide returns reflective of Chinese money market rates by purchasing and holding high-quality U.S. money market securities and forward currency contracts or swaps (Wisdom Tree, 2011). The greatest return was realized during 2013, but this was wiped out during the first five months of 2014 as the PBoC allowed the yuan market price to correct without interference (Figure 2).