Is China Weakening the Yuan to Fight U.S. Tariffs?
Fletcher School, Tufts University
The Issue:The Chinese currency has declined in value against the dollar by over 7 percent since mid-May. This lowers the cost of Chinese exports to the United States and could help counteract the effect of United States tariffs that would make imports from China more expensive. The Trump administration has interpreted the weakening of the yuan against the dollar as an effort to undo the effects of the proposed 10 percent tariffs on Chinese goods, and has responded by threatening to raise the proposed tariff rate to 25 percent. Is China using the value of its currency to soften the blows in the trade spat with the United States?
The flip side of a weakening yuan is a strengthening dollar. So, is the Chinese currency weak, or is the dollar strong? The answer, as it turns out, is “yes.”
- The Chinese government largely controls the value of its currency. Unlike the United States, where the value of the dollar is determined by market forces, the Chinese government exerts more active control over its currency through restricting capital flows into and out of the country, using its foreign currency reserves to intervene in the foreign exchange market, and regulating foreign currency trade. But the Chinese government faces a dilemma; it would like to have a more market-determined exchange rate to make the yuan an “international reserve currency” and to make its capital markets more attractive to overseas investors, even while it wants to maintain control over its currency’s value to keep its exports competitive. Also, any government that pegs its currency cannot do so simultaneously to all other currencies since cross-exchange rates among those currencies change over time. Authorities that peg must do so to one other currency, or to a small basket of currencies. The exchange rate between the yuan and the United States dollar is likely a key focus of the Chinese authorities as they manage the value of their currency.
- The yuan has weakened against the dollar, and more broadly against other currencies as well, over the past four months. The bilateral yuan / dollar exchange rate has depreciated since the Spring of 2018, after a run up in its value that began in the summer of 2017 (see solid black line in the graph – note that the reverse scale of the axis means that a fall in the value represents a weakening of the yuan against the dollar). The yuan has fallen about 8 percent against the dollar since the beginning of April 2018. But this movement is not restricted to the dollar; a trade-weighted average of China’s bilateral exchange rates with 61 countries fell by about 5.7 percent between late May and the beginning of August 2018. (This trade-weighted yuan index, the solid red line in the figure, is calculated by the Bank of International Settlements). The figure shows, however, that the broad yuan index is currently at about the same value as it was at the beginning of 2017. Indeed, economists from the International Monetary Fund (IMF) have calculated that the yuan was currently close to its market-determined value in late June, 2018 (see the chart on page 11 of the 2018 IMF External Sector Report). But the yuan has weakened against a broad index of other currencies by about 4½ percent since then. This most recent weakening of the Chinese currency may be a purposeful move by authorities to bolster an economy that is showing signs of softening.
- The broad weakening of the yuan against many currencies is matched by a broad strengthening of the dollar against a wide range of U.S. trading partners. An index of the United States dollar against 61 currencies (calculated by the Bank of International Settlements, the solid blue line in the figure) has strengthened by about 9 percent since the beginning of February 2018. An important determinant of the market-determined value of the dollar is the prospect for interest rates and economic growth in the United States as compared to conditions in other countries. Both higher interest rates and faster growth, either now or expected in the future, lead to a rising value of the dollar. Thus, the continued strength of the U.S. economy and the likelihood that the Federal Reserve will raise interest rates to keep the economy from overheating have both contributed to the dollar’s strength.
- Because the volume of trade between China and the United States is so high, it is possible that changes in the yuan / dollar exchange rate would dominate indexes that look at a broader set of currencies. Absent its strength against the yuan, has the dollar strengthened against other currencies as well? And absent the weakness of the yuan against the dollar, has the yuan weakened against other currencies? To investigate this, I excluded the dollar from the yuan index, and the yuan from the dollar index, to get an index of the dollar against 60 countries that do not include China (the dashed light blue line in the figure), and an index of the yuan against 60 countries that do not include the United States (the dashed pink line in the figure). I assumed a China – U.S. trade weight of 20 percent in both of the broad BIS indexes (the actual trade weights are very close to 20 percent, and vary a bit over the time period). The figure shows that there is a very high correspondence between the broad indexes and the ones that exclude the dollar / yuan exchange rate – the correlation between these indexes is about 97 percent. Thus, recently the strength of the dollar and the weakness of the yuan extend well beyond the bilateral exchange rates of the two countries.
What this Means:
The weakness of the yuan against the dollar has been cited as a reason to impose higher tariffs on China by the Trump administration. This weakness seems to be broad-based, and not targeted against the United States. Likewise, the strength of the dollar is broad-based as well, and likely due to the strength of the U.S. economy and the prospect for higher U.S. interest rates. While a weaker yuan does soften the impact of U.S. tariffs on Chinese exports, domestic economic factors in both China and the United States are important underlying contributors to the change in the value of the dollar/yuan exchange rate. For now, the weakening of the yuan and the strengthening of the dollar are both likely to exacerbate trade tensions. Beyond the question of whether the trade war has shifted into a currency war, these currency moves make narrowing the bilateral trade deficit between the countries — one of the Trump administration's stated trade goals (despite the fact that this is a deeply flawed statistic) — more difficult and, with that, comes a greater risk of a broadening trade war.