What Yuan About?


Politicians, entrepreneurs and economists across the world are currently getting particularly het up about exchange rates. Eoin Brady explains why

Back in primary school, currencies were a simple affair. If the punt was strong, we were happy, because it meant we could buy more Orangina and Haribo on our summer holidays in France. When the euro arrived on the scene, things got even easier: now we knew how much Orangina and Haribo we could get without having to multiply exchange rates in our heads in the supermarket. Back then, that was as complicated as currencies got.

However, if you happen to be in the business of manufacturing goods for export, exchange rates are rather more contentious and emotive.  If your company makes a product to sell abroad, it is in your interests for it to be as cheap as possible for your buyer, so they buy more. The price they pay will be determined not only by things within your control – for example, how much you pay your staff – but also by the exchange rate between your currency and your buyer’s.

For example, imagine you make bicycles in Manchester, and you can afford to sell them for £100. You want to sell your bikes to French cyclists. One of your bicycles would cost them, say, €120. But if the euro suddenly weakens against sterling, our French person would have to pull together €130 to get the same £100. This means that your bicycles have become considerably more expensive, and less desirable, to the French person, and it’s completely outside of your control.

This scenario is being played out on a grand scale at the moment and people are not happy. In the US, populist rhetoric abounds: Republican representative Mike Rogers declared that the Chinese “cheat to steal our jobs”. The Brazilian Minister for Finance Guido Mantega has declared that a “currency war” is underway. A Chinese spokesperson colourfully described the US as the currency war’s “tomb-maker,” meaning – in Chinese idiom –  “one who sets a bad precedent”.

The reason for all this hot air is that some countries believe that others are engaged in the act of currency manipulation. This means deliberately acting, over a prolonged period, in a way that causes the currency of your country to be undervalued in comparison to that of other countries. In the bicycle example, it would be like the Bank of England making £100 be worth €110, and thereby making its producers’ bicycles more desirable in France. France’s bicycle manufacturers would be unable to compete, and would go out of business.

In reality, there are two key forces behind the conflict here. First, there is China’s currency policy. China is currently keeping its currency pegged to the US dollar. This means that China acts to keep the exchange rate between the two currencies fixed.

The way it does this is first by deciding what it wants the exchange rate to be. Then it goes to the exchange rate market, where it sees that yuan are actually more valuable than it wants as there is an excess of buyers of yuan at the set price. It then buys dollar-denominated financial instruments, like US government bonds, with yuan. This puts out more yuan and mops up the surplus dollars, and keeps the system going, making Chinese exports artificially competitive on the global market.

Nobel laureate Paul Krugman characterises China’s behaviour as “predatory and beggar-thy-neighbour”. The reason the actions can be reasonably described thus is that currency exchanges are an example of a zero-sum game. A zero-sum game is a situation where every gain a competitor makes brings about an equal loss for someone else. This contrasts with a positive-sum game, where certain actions lead to the creation of wealth. Every gain China makes by weakening its currency is offset exactly by an equally large loss incurred by its trading partners.

The second issue is that of quantitative easing in developed economies. In order to stimulate the US economy, the Federal Reserve has effectively printed money, and may do so again. This increases the supply of dollars, making the price of dollars fall. In turn, this makes the dollar’s exchange rate to other currencies fall. And with yuan pegged to the dollar, it falls too.

Having two of the world’s largest economies’ currencies weakening makes life very difficult for everyone else that would like to trade globally. Other countries, including South Korea and Switzerland, have attempted to keep down their currencies – a portent that a global game of beggar-thy-neighbour could be in the offing.

This is a problem for which there is no simple solution. China has moved, under US diplomatic pressure, to allow its currency to appreciate slightly since June. At present, a bill awaits approval by the US Senate and President Obama that would enforce punitive tariffs on certain imports from China. The balance that needs to be struck is between taking an excessively delicate approach with an assertive new global power, and further stoking its ire. Much more complicated than Haribo and Orangina.