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How the People's Bank of China Has Responded to a Falling U.S. Dollar Exchange Rate

By Frances Coppola

Companies engaging in international trade tend to keep a close eye on the dollar's exchange rate with China's yuan, given that China is at present the United States' third-largest and fastest-growing export market, and our number one import partner. As China is also our only large trading partner whose currency is managed rather than freely floated, this article provides some historical context for how the People's Bank of China (PBOC) manages the yuan's exchange rate, along with experts' thinking on the currency's more recent moves.

Currently, the world has five "reserve currencies," which together make up the International Monetary Fund's (IMF's) SDR basket.1 The exchange rates of four of these – including the U.S. dollar, the world's premier currency for international payments – float freely against each other. But the fifth is the Chinese yuan (CNY), which was added to the SDR basket in 2015 – and whose exchange rate is actively managed by the PBOC.


How the PBOC Manages the CNY-USD Exchange Rate


Over the last couple of decades, the PBOC has progressively adapted its exchange rate management approach to meet the needs of an increasingly open Chinese economy. In 2010 it moved from a hard USD peg to allowing the CNY to trade within a fluctuation band around a reference rate. Initially this rate was determined principally by the USD exchange rate, but in 2015 the PBOC moved to setting the rate by reference to a weighted basket of 13 currencies.2 The fluctuation band has also progressively widened, from plus or minus 0.5 percent in 20123 to plus or minus 2 percent today,4 and may be widened further.5


Also, as part of its efforts to internationalize the currency, the PBOC introduced an "offshore yuan" (CNH) in 2010 so that the Chinese currency could be traded though Hong Kong without the PBOC relinquishing control of the CNY exchange rate.6 The fact that the CNH's exchange rate was market determined, whereas the CNY's exchange rate remained managed, caused a gap to form between the two rates. In August 2015, the PBOC abruptly devalued the CNY, closing the CNY/CNH gap. It also announced that in future it would use the prior day's CNY market exchange rates versus its 13-currency "basket" to set the current day's reference rate. China's move to this more market-led regime led to the IMF decision to include CNY in the SDR basket.7


At the time, analysts wondered whether the PBOC's change of approach signaled an intention to float the yuan, eventually. However, more than two years later, the PBOC still routinely intervenes in forex markets to guide CNY's. The PBOC has settled on a "managed" or "policy-guided" exchange rate regime for CNY, rather than a free float.8


What is Currency Manipulation?


The fact that the PBOC actively manages the CNY currency exchange rate has at times led to accusations of "currency manipulation."9


Economic theory says that a low exchange rate tends to benefit exporters at the expense of importers, and vice versa. Thus, when a country deliberately keeps its currency exchange rate below the level that it would be if its exchange rate were floating, it runs the risk of being accused of manipulating its currency to gain an unfair trade advantage. Because countries are liable to respond to unfair competition by imposing barriers to trade, currency manipulation is discouraged by international bodies such as the IMF10 and opposed by the U.S. government.11


However, whether keeping the exchange rate below its natural (floating) level amounts to trade cheating depends on the circumstances. For example, Switzerland runs a persistent trade surplus,12 which can be an indicator of currency manipulation. But when the Swiss National Bank capped the franc's exchange rate during the Eurozone crisis, analysts accepted that the purpose was to protect the Swiss economy from the inflationary effects of a large inflow of risk-averse capital looking for a safe haven.13


Similarly, the Bank of Japan's negative interest rate on deposits depresses the exchange rate of the yen.14 But despite Japan's substantial trade surplus, analysts generally agree that the main purpose of the Bank of Japan's monetary policies is to stimulate domestic economic growth and raise inflation, not to gain export advantage.15


Is China manipulating its currency exchange rate?


The PBOC is legally mandated "to maintain the stability of the value of the currency," which requires it to actively manage the CNY exchange rate. But it is not always easy to distinguish between actively managing an exchange rate and manipulating it to gain an unfair advantage. Some point to China's persistent large trade surplus as evidence of currency manipulation to benefit Chinese exporters.16


If it is, economists believe the relationship of the CNY-USD exchange rate to the USD trade-weighted exchange rate (dollar index) could reveal it. The exchange rate of a currency that is being manipulated to benefit exporters would typically float downwards when the currency exchange rates of major trade partners are rising, but would be prevented from rising when the currency exchange rates of major trade partners are falling.


But lately, when the dollar index has fallen against other major currencies – notably the euro and the Japanese yen – the CNY's exchange rate has risen by a roughly equivalent amount. Analysis done by the Financial Times shows that the 6.1 percent fall in the dollar index since November 2017 to early February 2018 has been matched by a 5.6 percent rise in the CNY-USD exchange rate.17


Of note, this was not quite the case until recently. The Financial Times analyst observes that between January and September 2017, when the dollar index fell 11.5 percent, the CNY-USD exchange rate only rose by 7.6 percent. And in 2016, when the dollar index fell by 7 percent between January and May, CNY-USD only rose by 1.5 percent.18


Some analysts say that the fact that the CNY-USD now correlates better with the dollar index indicates that the PBOC is becoming more relaxed about allowing the currency exchange rate to move with the market. Others speculate that the PBOC is responding to political pressure from major trade partners.19


But there are other reasons why the PBOC might seek a stronger CNY-USD exchange rate. Chinese banks and corporations have issued large amounts of USD-denominated debt, and many are now financially fragile. A stronger CNY versus USD reduces the external debt burden for these companies and banks, potentially reducing the risk of a financial crisis in China. Additionally, a stronger CNY helps to discourage capital flight, potentially enabling China to relax its capital controls.20



The PBOC appears to be moving more towards a market-determined exchange rate policy for the CNY. If the USD's trade-weighted exchange rate remains weak, this may be a boon for U.S. businesses exporting to China, especially if China relaxes capital controls as a result.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years' experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.


1. “Special Drawing Right (SDR),” International Monetary Fund;
2. “China’s Exchange Rate Policies and U.S. Financial Markets,” Federal Reserve Bank of San Francisco;
3. “People’s Bank of China widens yuan-dollar fluctuation band from 0.5% to 1%,” Bank of Finland;
4. “China Pulls the Trigger on Yuan Band Widening,” The Wall Street Journal;
5. “China eyes widening yuan band amid reform pressures,” Reuters
6. “Offshore Chinese Renminbi Market (CNH),” CME Group;
7. “The battle of midpoint,” The Economist;
8. “A few words on China’s “new” exchange rate regime,” Council on Foreign Relations;
9. “US says China “manipulating” renminbi,” Financial Times;
10. “Article IV of the Fund’s Articles of Agreement; An Overview of the Legal Framework,” International Monetary Fund;
11. “Foreign Exchange Policies of Major Trade Partners of the United States,” U.S. Treasury;
12. Switzerland trade summary, World Bank;
13. “Swiss Central Bank Acts to Put A Cap on Franc’s Rise,” The New York Times;
14. “Japanese yen takes a deliberate dive to keep things turning,” The Guardian;
15. “Abenomics and the Japanese economy,” Council on Foreign Relations;
16. “Scoring the Trump Economic Plan: Trade, Regulatory and Energy Policy Impacts,” Donald J. Trump website;
17. “Renminbi flies as Beijing removes shackles,” Financial Times;
18. Ibid.
19. Ibid.
20. Ibid.

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