If you’ve been paying any attention at all to financial markets in recent years you’ll know China’s currency – the renminbi or yuan – is often in the spotlight. The reason? There is a belief, in some corners at least, that China is artificially keeping the value of its currency low to provide an unfair advantage to its economy.
A currency manipulator?
Whether this is true or not is up for debate. The IMF, for instance, believes the currency is broadly in line with its fundamentals. In August 2019 though, the US Government officially branded China a currency manipulator following a sudden fall in the renminbi. The Biden administration walked that designation back, but has kept China on a watch list over its currency practices.
Either way, it’s clear the Chinese currency is something traders and investors across the globe need to keep an eye on over the next few years.
To understand why there is so much focus around the renminbi, it helps to understand exactly how it differs from other major currencies.
Broadly speaking, there are two types of currencies – floating and pegged. The latter are governed by market movements – rising and falling according to demand and economic fundamentals – while the former are pegged at a certain rate, usually to the US dollar or a basket of currencies.
Free-floating currencies are the norm for developed economies while pegged currencies are more common in the developing world because they may help to provide stability.
A third way
The renminbi doesn’t quite fit neatly into either of these categories. From 1994 to 2005, the currency was pegged at 8.3 yuan to the US dollar until pressure from major trading partners prompted the government to move to a new “managed float” system.
Under this approach, the currency is pegged to a basket of currencies but allowed to move within two percentage points of a reference rate set by the central bank daily. The currency has been allowed to gradually appreciate since then, but has moved in a fairly narrow range, mostly between 6 and 7 yuan per dollar over the past decade.
These tight controls help explain why the renminbi is yet to take on the same significance in currency markets that China does in global trade. While the Chinese economy is the second largest in the world, trade in the renminbi is a small fraction of that of the USD.
But that is expected to change in the future as Beijing gradually liberalises the currency.
Future moves
In 2015, the International Monetary Fund added the renminbi to its special drawing rights basket – an international currency reserve available to member countries, alongside the US dollar, the Japanese yen, the euro and the British sterling.
The move helped lift the renminbi’s status as a reserve currency, which confers a number of benefits, including ultimately allowing China to price trade contracts in its own currency, reducing foreign exchange risk and transaction costs.
It has a long way to go to match the likes of the US dollar but there are small signs of change. At the end of 2020, the US dollar’s share of global currency reserves fell to its lowest mark in 25 years, accounting for 59% of global reserves, while the renminbi climbed to 2%.
Still, as China’s economic influence grows, many believe it could eventually replace the dollar as the world’s dominant currency.
The more immediate fear is that China could continue to devalue the its currency to offset the effect of US tariffs and maintain or increase its competitive export advantage.
China does appear to have some form when it comes to pushing the currency lower – including in 2015 when it surprised markets by allowing it to fall more than 3% over three days.
However, while significantly lowering the yuan may hurt the US, it would also hurt Chinese consumers by pushing up the price of imports and could also see a significant flow of money out of the country as investors look for more stable places to park their money. It would also undermine China’s efforts to lift the global status of the renminbi. In other words, a sharp currency devaluation could potentially be bad for both sides of the Pacific.