Some Thoughts on China’s Alleged ‘currency Manipulation’ – It’s a Story That Falls Apart Under Close Examination

My CD blog post a few days ago on China’s alleged “currency manipulation” (“We should thank, not condemn, our generous Chinese benefactors for ‘manipulating’ the currency in our favor“) provoked a lively discussion and generated more than 100 comments so far. Here’s another post on the topic of currency manipulation, with a few additional thoughts:

1. Claims have been for a least a decade that China has been manipulating its currency for at least 15 years to keep the yuan artificially undervalued (and the US dollar artificially overvalued) to allegedly gain an unfair advantage over the US in trade. With a “manipulative” strategy of keeping the yuan weak and the dollar strong, China can artificially boost exports to the US by lowering the dollar cost of its exports, and artificially reduce our exports to China by raising the yuan cost of US products.

And yet the top chart above of the Yuan/USD exchange rate (inverted) shows that the yuan was steadily appreciating between 2005 and 2014, a period during which China was allegedly engaged in currency manipulation to keep the yuan undervalued. During that period, the yuan appreciated (and the dollar depreciated) by 27%, which means that China’s exports to the US got 27% more expensive in dollar terms. That trend in the yuan appreciating significantly over almost a ten-year period seems to run counter to the arguments made that China was keeping its currency artificially undervalued. If so, shouldn’t the yuan have depreciated instead of getting stronger, and the dollar appreciated instead of getting weaker? Of course, China might have tried to prevent the yuan from appreciating even more, but the fact remains: the dollar was depreciating steadily between 2005 and 2014, and China’s exports were getting more expensive in dollar terms, not less expensive.

Since 2014, the dollar has appreciated by about 15% compared to the yuan, but that’s actually part of a general trend of the dollar appreciating vs. most currencies over that period of about 20% on average. Still doesn’t seem to be a lot of evidence of currency manipulation by looking at the Yuan/USD exchange rate.

2. Based on recent email correspondence with Morganovich, there are some serious potential, overlooked problems with the “China engages in currency manipulation to gain an unfair advantage and expand its exports” narrative, and reasons that the currency manipulation strategy might not work the way the critics, American manufacturers, and politicians think it works.

Here’s the problem with the currency manipulation story —  it only looks at one side of the production ledger — China’s exports to the US — and ignores the other side of the ledger — the cost of inputs for China to produce its exports.

The consensus story goes something like this:  “Aha! The yuan is artificially undervalued so Chinese tires, computers, clothing, furniture, appliances, and household goods are too cheap for Americans and this is unfair competition!”

But is this really so? Tires are made of rubber. China does not grow rubber, it imports it. Clothing is made from cotton, which China imports from the US and other countries. Computers contain semi-conductors and microchips, which are imported from the US and other countries. China needs other inputs, industrial supplies, commodities and materials like chemicals, copper, plastics and lumber, and many of those inputs are imported from the US (see table above). To produce its manufacturing output, China needs equipment and machinery, and much of that comes from the US.

The table above shows that of the top 20 US exports to China, most of them are inputs and equipment that China purchases from the US to produce output, and output that often returns and comes back to the US as an import (see the top 20 US import categories for goods from China above).

An undervalued yuan would also make energy products like LNG and oil more expensive for China, which is now the world’s largest net importer of petroleum and other fuels. Higher energy prices in China from an undervalued yuan raise production costs there, and also contribute to making its goods more expensive when exported to countries like the U.S.

Here’s the frequently overlooked part of the currency manipulation narrative: Since China needs to import raw materials, inputs, supplies, parts and equipment to manufacture goods, what happens? It has to buy all of those inputs and equipment with undervalued yuan. As a direct result of the undervalued Yuan, the inputs from the US and other countries are more expensive for Chinese producers, which has to increase the prices of the goods manufactured there. Those higher prices for inputs from an undervalued yuan could actually make its manufactured goods more expensive overall when shipped to the US than they otherwise would have been.

Bottom Line: The actual overall effect of China’s “currency subsidy” could be negligible, since an undervalued yuan would significantly raise the production costs of manufactured goods and therefore raise the final product prices when exported, making “Made-in-China” products less competitive. The whole “currency manipulation” narrative mistakenly treats China’s output prices as a fixed, exogenous variable, when in fact it’s not. The price of China’s output is driven by the cost of its inputs, and the prices of those inputs rise if the yuan is undervalued. To the extent that an undervalued yuan significantly raises prices for imported inputs, the entire “currency manipulation to gain an unfair advantage for China exports to the US” completely falls apart.

(Special thanks to Morganovich for his contributions to this post.)