A Brief Overview on RMB and the US Dollar

The topic of China and the US is always hot and the relationship between China and the US is too complicated to be fully explained. There are always different views and arguments from different stances are just there to be picked up. You will never feel alone when you try to say some words about China and the US. Out of this reason, I would like to write some things about the relation between RMB and the US dollar.

A brief discussion on RMB and the US dollar would be started from 1994 when China adopted the policy to peg against the dollar at 8.28 yuan per dollar. At that time, China faced severe inflation (the inflation rate in 1994 was 24%). As a result, China took the policy of pegging against the dollar to stable the dollar prices for the goods they sold in the United States.

With the country’s ability to control the national economy increasing, China was gradually able to bring down the inflation rate at a very low level and keep the fast economic growth rate at an average of about 9%. The demand for RMB and the dollar began to change accordingly. By the early 2000s, many economists argued that the yuan was undervalued against the dollar, possibly significant so.

This point was well taken use of by those politicians in the US to explain the great trade deficit of the United States. The pressure on China’s currency to appreciate was since then became heavier. Any policies Chinese government used to keep RMB stable might be regarded as a violation of the common practice and was irresponsible for the international financial market. Is that true? Or more specifically, are those policies really hurt the United States that much?

If you are equipped with some macro-economic knowledge, you should able to establish the demand and supply model for RMB and the US. If the exchange rate between RMB and the dollars is significantly undervalued as argued, then the exchange rate should be well below the equilibrium exchange rate. This leads to a shortage between the supply and the demand for RMB. The shortage should pressure the Chinese yuan to appreciate until it gets to the equilibrium exchange rate. However, since Chinese yuan was pegged against the US dollar, Chinese government had to cover the shortage by selling RMB and purchasing US dollars. In reality, Chinese government chose to purchase large amounts of US Treasury bonds to keep the fixed exchange rate.

From the US perspective, since Chinese government purchased a lot of US Treasury bonds, the artificial exchange rate can be kept at 8.28 and thus the US dollar do not need to depreciate and the large demand for US Treasury produced by Chinese government helped to keep the US interest rate at a quite low level. As a result, the US did not need to pay large interest to keep stable of its exchange rate with other major currencies and this helped the US a lot to keep its economic growth. If the demand-supply shortage occurred for a developing country rather than the US, then probably the economy would fall into the vicious cycle of borrowing a lot of US dollars to keep the country’s foreign reserves and paying huge interests as a heavy burden.

The previous interpretation helps to articulate that the fixed exchange rate did not influence the US economy too much and since the dollar is the world currency, China compensated the US loss by purchasing its government treasury bonds. Then is there something wrong with the US trade sector as those politicians’ argument?

The US great trade deficit is a fact. No one is going to decline. However, it is not much to do with China. Although it seems that the US has a large trade deficit with China, the problem is that US has a large trade deficit with nearly all the countries and the proportion of that with China is not that large.

One way to explain the US trade deficit is the relationship between the government budget deficit and the current account which is greatly influenced by the balance of trade. To explain this relationship, we should have a look at the formula S = I + NFI, where S stands for savings, I stands for domestic investment and NFI stands for net foreign investment. In a closed economy, it is obvious that all the sources for investment are from the total savings of the country. A little different from the conclusion is that in an open economy, the savings of the whole country can invest in the domestic market and the international market as well. As a result, we get the formula S = I + NFI. If government tends to have a budget deficit, savings tend to be small. To boom the economy, the US needs a lot of domestic investment. Thus the NFI (net foreign investment) should be a negative number, which means that the US need the investment from other countries and its financial account should be positive. The zero-sum relation between the current account and the financial account then hints that the current account should be negative. That is to say the policy of holding budget deficit results in the large trade deficit. The US actually designs its development pattern itself!

There are other ways to explain why the US always has a large trade deficit. I would not explain all of them this time. But no matter how we explain the situation, Washington has the enough influence to press the counterpart in China to appreciate the Chinese yuan at least a little. China claimed, in 2005, to give up the policy of pegging against the dollar and to adopt the policy to link the value of the yuan to the average value of a basket of currencies that would include the dollar, the Japanese yen, the euro, the Korean won, and several other currencies.

The argument has not come to an end. Many US politicians are not satisfied the pace of appreciation of RMB, and they may push harder for a strong Chinese yuan. Is China able to stabilize its economy by change the value of its currency gradually? Maybe time can tell us everything.