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China is hurting the U.S. dollar

At the end of the Second World War the US Dollar (USD) assumed the position of the world’s reserve currency.[1] This was a likely choice because the American economy was thriving and its currency was backed by gold. However, as economies grew larger and gold became scarcer, the USD essentially began to restrain its economy because the money supply could only be increased relative to world supply of gold.[2] Dropping the gold standard enabled the Federal Reserve (the Fed) to print money and thus manipulate the money supply, causing inflation which enabled the economy to grow. While most industrial nations chose to float their currencies relative to the USD, some underdeveloped countries chose to ‘peg’ their dollar to the USD. As most underdeveloped countries have non-existent financial and legal regulations, tying its currency to the USD creates economic stability, and thus, enables the underdeveloped nation to participate in the world economy. [3]

Over ten years ago, China pegged its currency to the USD and has since kept the exchange rate at 8.28 Yuan to 1 USD.[4] At the time, China’s economy was floundering and it couldn’t participate effectively on the world market because its economy was unstable. Chinas economy is now a global economic powerhouse mainly because the currency peg is protecting the Yuan from appreciating on the world market and this is creating an imbalance in the US economy.[5] This imbalance is caused by Chinas refusal to increase the ratio of Yuan’s per USD.[6] In order for China to peg its currency to the USD, China’s central bank has to actively participate on the world currency market by purchasing and selling its currency.[7] For example, when the world demand for the Yuan increases and it appreciates in value this threatens the peg; consequently, the Peoples Bank of China (PBC) must then devalue its currency by flooding the world currency market with Yuan and selling it in exchange for US denominated financial securities, such as US Government bond indentures. If the PBC failed to sell off the Yuan as its value increases, the exchange rate would no longer be fixed at its pegged rate and this would have negative effects on the economy.

Conversely, when the world demand for the Yuan decreases its price drops and PBC must sell some USD denominated financial securities and buy large amounts Yuan on the world currency market; thus creating demand for the Yuan which then brings its value back to the pegged level. These balancing transactions ensure the Yuan remains fixed with the USD. Consequently, China’s rapidly growing economy has caused an increase in world demand for its currency, and thus the PBC is continually required to sell off the Yuan to ensure the pegged rate is unchanged. However, the PBC can increase the money supply by printing more money. In contrast, if the Yuan was using the gold standard, it would have a static amount of money supply. Eventually China would run out of money to sell and this would untie the currency from the USD. [8]

If the Yuan was untied from the USD, the demand for its currency would cause it to appreciate, while at the same time, the high levels of money in the economy would create unusually high levels of inflation[9]. Because higher levels of money result in higher prices for goods, higher prices cause wages to increase. As a result, China’s economy would be negatively affected. When the money supply is increased at a controlled rate, however, prices of goods increase, inflation occurs, and the economy grows proportionate to the desired rate – this helps China’s economy grow at such large rates.[10] The bullish economy requires the sell off of Yuan in exchange for US currency. Therefore, China has accumulated large reserves of US currency giving it the ability to manipulate its Yuan on the world market in order to propagate its economy. [11]

The Yuan is undervalued because the peg keeps it from appreciating on the world market. This creates demand for Chinas exports because foreign markets can buy Chinese exports for a lower rate than it would normally be under a floating currency. The high levels of consumption in the American economy and the relatively low levels of goods it exports has caused trade imbalance (deficit) to occur in America’s current account balance with China.[12] Essentially, the US economy is inadvertently absorbing China’s negative economic externalities because the value of its current account deficit with China is overstated due of the falsely undervalued Yuan. Basic economic principles would suggest that Chinas rapid increase of money supply normally should result in high inflation and negative economic consequences. But because of the currency peg, the negative consequences of Chinas inflationary economy are shifted to the USD by decreasing the real value of the USD in relation to US’s current account deficit with China.

Currently the US trade deficit with China is close to $600 billion dollars[13]. Cheap labor has helped China produce inexpensive manufactured goods, which the American economy buys. As America buys more goods from China, more USD flow to China – resulting in China accumulating a large trade surplus with the USA[14]; a large trade surpluses results in an increase in amount USD in the Chinese economy, which further gives the Chinese economy stability and economic power.[15] China then uses this surplus to import raw materials so it can continue to manufacture goods to sell to the USA. This perpetual cycle hurts the US economy greatly.[16]

The US economy could benefit greatly if the Chinese government allowed its currency to float on its own. If the Yuan was detached from the USD, the value of the Yuan would likely appreciate causing the Chinese economy to moderately slow down resulting in a decreased demand for the Yuan. A decrease in demand for the Yuan would force the PBC to sell off its reserves of US currency in order to curb the appreciation of the Yuan. This would cause devaluation in the real value of deficit for the US economy’s current account.[17] Recently the Bush administration has been urging China to let its currency float on its own in order for the market correct the value of the Yuan. Downward pressure on the USD would be decreased because the real value of the current account deficit would be decreased significantly.[18]

Chinas refusal to detach its currency from the USD is causing the Yuan to be undervalued and this is the primary reason for the unbalanced current accounts between the two countries.[19] However, China has seen its economy prosper by pegging its currency to the USD but this has caused a rapid increase in the money supply. High levels of inflation could be realized, at least temporarily, if the Yuan is detached from the USD, though an increase in the value of the Yuan, at least to a certain extent, will help reduce the USD’s recent decline on the world markets. Conversely, many other Asian countries would not support the detachment of the Yuan because it is considered the stabilizing currency in the region.[20] However, America’s economy is currently being eroded by Chinas failure to float its economy on the world market. The downwards pressure the Yuan is exerting on the USD is deteriorating the US’s ability to stop the negative trend in its dollar while the Chinese economy is benefiting by an increase in exports.[21] Either way, the Yuan must be corrected soon by the market before it devalues the USD too the point where its own economic system could crash as a result of it being pegged to the United States Dollar.[22]
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