Thursday, April 8, 2010

Appreciation of the Yuan: Good for the US, Good for China, Too

From 2005 until the onset of the global economic crisis, China had allowed its currency, the yuan, or RMB, to appreciate gradually relative to the U.S. dollar. The appreciation was halted in July 2008. Since that time, China has held the exchange rate fixed at close to 6.8 yuan per U.S. dollar. Now China may soon allow the yuan to begin appreciating again. Why?

During the worst phase of the crisis, a weak yuan served Chinese interests well. Preventing appreciation helped keep the price of Chinese exports low for buyers in the United States and elsewhere. At the same time, it raised the price of imports to Chinese buyers. As a result, China's current account surplus shrank only moderately during the crisis. Together with other expansionary policies, including a huge government stimulus package and encouragement of rapid growth of bank lending, the currency policy allowed China to keep its economy expanding through 2008 and 2009. It its worst quarter, growth of Chinese GDP never fell below 6 percent.

 The effects of China's currency policy were not so welcome in the United States. A weak yuan meant that importing from China was more attractive and exporting to China was harder. That kept the U.S. current account surplus high and slowed U.S. recovery from the recession. Angry voices in Washington and elsewhere have labeled China a "currency manipulator" and demanded renewed appreciation of the yuan.

China's leaders would be very reluctant to be seen to revalue the yuan in response to foreign pressure. However, they have other reasons to consider a change in currency policy. A weak yuan has unpleasant unintended consequences for China, too. In order to prevent appreciation of the currency, the Chinese central bank must purchase billions of U.S. dollars to add to its currency reserves. Those dollars a paid for with newly issued yuan, causing China's money stock to grow at an annual rate averaging more than 30 percent.

Although the central bank has used administrative controls, sterilization, and other tools to help contain inflation, it is getting harder and harder to stem the tide. After several months of mild deflation in mid-2009, the Chinese consumer price index is beginning to rise again. Although CPI inflation is still moderate at about 2% (as of February), inflationary pressures are more strongly felt in the labor market and the housing market of coastal cities.

The bottom line: Chinese leaders now seems poised to allow the yuan to begin appreciating again, not because of U.S. pressure, but primarily to restore macroeconomic balance to their own economy.

To download a free set of PowerPoint slides with graphs and discussion related to Chinese currency policy, follow this link. If you find these slides useful in your economics classes, please post a comment or send me an e-mail.


  1. Hi Ed,

    It would be great if you could give us a status update on China and their propping up of the Dollar.

    My question also is: Money used to purchase foreign currency is out of circulation (i.e. held by other countries) is it not? Are there really inflationary pressures involved?

  2. I'm working on a new post on this, it will be up in a few days when I finish a couple other things.

    Meanwhile, to try to answer your question: If the Chinese central bank (PBoC) buys dollars to add to its reserves, the dollars are, I suppose, "out of circulation," if you want to think of it that way. But the PBoC pays for the dollars with newly created yuan, and those yuan go into circulation in China. It is the new yuan sold, not the dollars bought, that create the inflationary pressure.