China affects the U.S. dollar by loosely pegging the value of its currency, the yuan, to the dollar. As of January 26, 2017, the U.S. dollar was worth 6.88 yuan. This exchange rate means that China’s central bank keep the yuan’s value at around that level. It guarantees to pay 6.88 yuan for every U.S. dollar redeemed. For more, see How Does the Government Regulate Exchange Rates?
China traditionally used a modified fixed exchange rate, as opposed to the United States and many other countries that have a floating exchange rate.
It compared the yuan’s value to a basket of currencies reflecting its trading partners. The basket was weighted towards the dollar since that’s China’s largest trading partner. It kept the yuan’s value within a 2 percent range against that currency basket. China managed its currency to control the prices of its exports. Every country would like to do this, but few have China’s ability to regulate it so well.
How China Manages Its Currency
China’s currency power comes from its many exports to America. The top categories are consumer electronics, clothing, and machinery. Also, many U.S.-based companies send raw materials to Chinese factories for low-cost assembly. The finished goods are considered imports when the factories ship them back to the United States. For more, see U.S. Trade Deficit With China.
As a result, Chinese companies receive dollars as payments for these goods and services.
They deposit the dollars into their banks in exchange for yuan to pay their workers. Banks send the dollars to China’s central bank, the People’s Bank of China (PBOC). It stockpiles them in its foreign exchange reserves. That reduces the supply of dollars available for trade. It then puts upward pressure on the dollar’s value, lowering the yuan’s value.
The PBOC uses the dollars to purchase U.S. Treasuries. It needs to invest its dollar holdings into something safe that also gives a return, and there’s nothing safer than Treasuries. For more, see U.S. Debt to China.
On August 11, 2015, the PBOC modified its peg to the dollar. It based the yuan’s value on a reference rate. That rate was equal to the previous day’s yuan closing value. The PBOC wanted the yuan to be driven more by market forces, even if it meant greater market volatility. The International Monetary Fund (IMF) required this for the yuan to be considered an official reserve currency. (Source: “The Yuan and the SDR,” The Economist, August 5, 2015.)
That allowed the yuan’s value to fall 2 percent, to 6.3232 per dollar. The next day it fell another 1.0 percent to 6.3845. To restore the yuan’s value, the PBOC used its dollar reserves to buy yuan from Chinese banks. That put dollars into circulation, lowering its value, and took yuan out of circulation, raising its value. By August 14, the yuan recovered 0.1 percent to 6.3908 per dollar.
China’s economy impacts the dollar’s value in other ways. China’s slowing economic growth and potential credit problems are two reasons why the dollar gained strength in 2014.
China’s stock market experienced an asset bubble that burst in early July, sending the exchanges into a correction. Stock prices fell more than 30 percent after hitting record highs on June 12, 2015. More than 700 companies listed on the Shanghai and Shenzhen stock exchanges asked to suspend trading–nearly a quarter of all firms.(Source: “China Firms Rush to Halt Trading As Stock Market Slumps,” CNBC, July 7, 2015.)
China is the world’s second largest center of stock trading after the United States. But prices typically swing more than 10 percent within a day. That makes it one of the world’s most volatile. That’s because individual investors, new to the market, make up more than 80 percent of trades. Most Chinese are 100 percent responsible for their retirement funds. The government doesn’t provide anything like Social Security. They feel they must “outperform the market” to boost their retirement earnings.
In fact, the market is too risky for institutional investors, such as pension and hedge funds, making it even more volatile. Unlike the United States, China’s government itself owns the biggest companies that dominate the indexes. That means government policies, regulations, and even announcements affect the value of the companies it owns. Knowing this, many Chinese investors try to make money by outguessing the government’s strategies and statements. (Source: “Why Are China’s Markets So Volatile?” CNBC, July 7, 2015.)
China’s leaders must carefully slow economic growth to avoid inflation and a future collapse. That’s because they’ve pumped too much liquidity into state-run companies and banks. In turn, they’ve invested those funds into ventures that aren’t profitable. For more, see Why China’s Economy Must Reform or Collapse.
If not managed carefully, China’s leaders could create a panic as some of these unprofitable businesses shut down. Bank loans support nearly a third of China’s economy. Almost a third of these loans are above the lending limits set by the central government. That’s because they aren’t on the books and aren’t regulated. They could all default if interest rates rise too fast, or if growth is too slow. China’s central bank must walk a fine line to avoid a financial crisis.
China’s mega-rich want to escape this threat. They are investing in U.S. dollars and Treasuries as a safe haven. The top 2.1 million families control between $2 trillion and $4 trillion in stocks, bonds, and real estate. China’s leaders must be careful in devaluing the yuan to prevent more capital flight. At the same time, if it keeps the yuan’s value too high, it will slow the economy too much, triggering capital flight just the same. (Source: Andrew Browne, “Megarich Keep Eyes on Yuan,” Wall Street Journal, February 25, 2015.)
Second, emerging market countries rely on exports to China to fuel their growth. As China’s growth slows, it will hurt some of these trade partners more than others. As their exports slow, so will their growth. Foreign direct investment will drop as opportunities dry up. Slowing growth weakens their currencies. Forex traders may take advantage of this trend to drive currency values down more, further strengthening the dollar.