Since the last half century, most of the international trade is done using USD as a standard currency. Consider the trade between US and China. US exports goods and services to China and gets USD in return. It does not have to convert it back to any other currency. But when China exports goods to US, it gets USD which it has to convert into Yuan to pay its workers, other expenses domestically.
Consider 2 scenarios.(Fictional values to provide case)
A) 1US$ = 10 Yuan (Implies every $ earned by Chinese will fetch them 10 Yuan)
B) 1US$ = 7 Yuan
Clearly case B implies stronger Yuan compared to case A. What do the people of China prefer??
Importers pay Yuan to buy US$ and then buy goods internationally. Hence they would prefer paying lesser Yuan to get a dollar and hence prefer case B.
Exporters receive US$ and convert it to Yuan and pay their expense, purchase raw materials, services within China. They prefer getting more Yuan per US$ and hence prefer a weaker Yuan which is case A.
There is a conflict of interest between both these camps and the government has to decide which camp to favor in-order to develop its domestic manufacturing at the same time not costing too much on imports. Most countries allow free fluctuation of currency rates so the currency is decided by the quantum of exports and imports. But countries like China have a tightly controlled currency.
(Note: Renminbi is the official name for the currency, and yuan is the main unit of currency)
In the 1990s, China set upon the path of liberalization but did not have any significant manufacturing base as it has today. Their aim was to provide employment to its huge population and having a huge manufacturing infrastructure was the only way ahead. China already has cheap labor as its biggest asset. All it required was good governance and "Undervalued" Yuan.
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| Historical USD/RMB(Yuan) chart |
Around 1980, the exchange rate was 1.5 Yuan /US$ ( 0.66$/ Yuan as from chart). Slowly, China de-valued Yuan to 8.62 Yuan/ US$( 0.116 Yuan/ US$) in 1994 and maintained around about the same rate till 2005. This clearly shows the peg being maintained for more than a decade. It was during this decade that China built a massive manufacturing base and attracted foreign investments in manufacturing sector.
Since the Yuan was heavily undervalued, every US$ gave more Yuan to Chinese exporters who could purchase cheaper labor and avail raw materials, other services at a very cheap rate hence enabling them to make extremely cheap goods and services.
These extremely cheap goods made the products from elsewhere around the world un-competitive and slowly started wiping off the manufacturing bases at many places. Eg USA, UK, France and other developed countries as they could not match the cheap labor, cheap currency and hence the cheap goods.
Even though cheap currency sparks inflation within the country the benefits of it were enormous to China as it catapulted China as a Giant Factory and simultaneously wiped off the competition elsewhere around the world.
We will analyze the foreign currency reserve scenario and other side-effects in the next section.
