As a trade war looms between the United States and China, the news out of Beijing is particularly interesting. Officials with the People’s Bank of China acknowledged that they are considering a devaluation of the yuan (or the renminbi (RMB)), in an effort to stymie the impact of the Trump tariffs on their exports to the United States. The strategy is mystifying, and if it actually executed, it just might work for them.
To call China a trade giant is an understatement. It is actually a trade behemoth that manipulates masterfully (more on the latter point in a second), exporting over $2 trillion dollars in goods and services globally. Consumer, commercial, and industrial markets in the United States, of course, make up significant destinations for those exports. In fact, sticky geopolitics notwithstanding, the United States and China share a pretty robust trade relationship. In 2016, trade between the two countries totaled nearly $650 billion. And, yes, for that same year, China did benefit from a roughly $385 billion trade surplus, relative to the total value of goods and services exported to China from the U.S.
The yuan, China’s currency, is pegged to a basket (or formula) of 13 major currencies, with the U.S. dollar now representing just under 25% of the weight of its basket. In order to remain an attract destination for the production of goods, the Chinese smartly realized that it had to keep, both, its currency from appreciating in value and its economy from freely heating up as a consequence of all of this new business.
The strategy that China uses to maintain some control is often referred to as the “impossible trinity”. No country can have free capital flows in its economy, a fixed exchange rate, and control of its monetary policy, at all times. China enforces strict capital controls in its economy. For example, citizens of China and ex-pats working there cannot freely exchange their yuan for any foreign currencies. And that is an important fact to remember when you think of the Chinese consumer, who is not spending much of the money that he has earned after working long hours in that demanding economy. (Even if you hear a lot of glamorous stories about young Chinese splurging on European cars or pricey flats, just know that it’s not everyone. In fact, the Gross Savings Rate as a percentage of China’s GDP is 50%, making the average Chinese household far, far more frugal than its American counterpart.) Consequently, as the people of China save more and more, that money gets invested into more projects (like real estate) and production capacity, even beyond what is necessary to meet domestic demand. In the beginning, much of that money went into building factories, and those factories exported their excess production to markets willing to receive cheaper goods, thus creating the types of trade surpluses that we now see with the United States and the European Union.