Till now, we have established that with a very weak currency (artificially kept weak) the export industry of a country gets boost. China, in order to make itself an exports hub, artificially pegged the Yuan to US$ and maintained it for more than a decade. The manufacturing base started picking up steam and soon China started exporting billions of dollars worth of goods worldwide.
Consider the following example.
- 10 Yuan = 1US$ is the official peg that China wants to maintain.(for example).
- China produces and exports goods worth $10 Billion to US. Hence, China receives $10 Billion which it need to convert into Yuan ( $10 Billion = 100 Billion Yuan).
- US produces and exports goods and services worth $5 Billion to China. Hence, China pays 50 Billion Yuan which is converted into $5 Billion and paid to US.
China : Pays 50 Billion Yuan
Receives 10 Billion US$ (equivalent to 100 Billion Yuan)
US: Pays 10 Billion US$
Receives 50 Billion Yuan ( equivalent to 5 Billion US$)
Here, China need to convert 10 Billion US$ to 100 Billion Yuan to have domestic use. But it has 50 Billion Yuan only to pay to US. Thus there is only 50 Billon Yuan in the system but there is a demand for more 50 Billion Yuan to match the excess 5 billion US$ received. Hence, Yuan is in demand here as more US$ is available and it needs to be converted into Yuan. Ideally, Yuan should appreciate as it is more sought after.
But the Chinese government has to maintain the peg constant and hence it needs to supply more Yuan without letting it appreciate. Hence, it simply prints more Yuan in exchange of US$. Hence, in this way, to supply Yuan, China prints 50 Billion Yuan and sucks up the additions US$ 5 Billion. The Yuan stays at the same peg due to this printing and remains artificially low, further assisting export industry in China.
The Chinese reserve bank now has US$ 5 Billion as its reserve against which it simply printed 50 Billion Yuan. As the trade keeps increasing and Chinese exports keep growing, China prints more Yuan to match the excess US$ received. It sucks the US$ and prints Yuan and keeps accumulating foreign currency reserve base.
Currently China has the biggest and most massive foreign currency reserve to the tune of $ 3197 Billion as of June 2011. It must be remembered that, had China not adopted a fixed currency regime by pegging theYuan to USD, the trade imbalance in its favor would have helped Yuan to appreciate and hence there would have been no need to absorb US$ to print Yuan and hence there would never have been such a massive foreign currency reserve base.
What China does with its massive foreign reserve will be discussed in the next post.
