China’s leaders want to improve the standard of living and increase its economic output. The Chinese have “pegged the yuan” to the US dollar but via an adjustable peg or “managed peg”. This floating peg has generally been on a downward trend since 2015 implying that the yuan has been steadily devaluing against the dollar, making Chinese exports relatively more competitive against dollar prices around the world. That allowed China’s economic growth to soar thanks to low-cost exports to the United States. As a result, China’s share of international trade and gross domestic product grew to around 10%. This has been a source of trade friction between China and the US.

As trade grew, so did the yuan’s popularity. In August 2015, it became the fourth most-used currency in the world. It rose from 12th place in just three years. It surpassed the Japanese yen, Canadian loonie, and the Australian dollar. Central banks should increase their foreign exchange reserves of yuan to provide funds for that level of trade. Central banks alone should purchase about $700 billion worth of yuan. But banks never purchased all the euros they should have, even when the European Union was the world’s largest economy. Most international transactions are still done in U.S. dollars, even though its trade has dropped.

The IMF requires China to liberalize its capital markets. It should allow the yuan to be freely traded on foreign exchange markets. That allows central banks to hold it as a reserve currency. For that to happen, China’s central bank must relax the yuan’s peg to the dollar. China must have clearer communications about its future actions regarding the yuan. That’s what the Federal Reserve does at each of its eight Federal Open Market Committee meetings.

In August 2015, the PBOC relaxed the yuan to dollar conversion rate.

Instead of a fixed exchange rate, it would set the yuan’s value to its closing value on the previous day. Instead of rising, as many expected, the yuan fell 3% over the next two days. The PBOC stabilized the rate. It now has the freedom to allow the yuan to be a stronger tool in monetary policy. The drop also silenced critics of China’s reforms, many of whom were members of the U.S. Congress. In December 2015, the Bank announced it would begin to shift the dollar peg to a basket of currencies. That basket includes the dollar, euro, yen, and 10 other currencies.

Any country that keeps its currency artificially low to boost cheap exports can be accused of currency manipulation. Countries with low currency values export more because their products cost less than their competitors’ products.

Currency manipulation is difficult to prove. A fixed exchange rate, by its very nature, exposes a country to accusations of currency manipulation. To make its case, the accusing country must prove that the accused kept its currency low simply to increase exports. In August 2019, the U.S. designated China as a “currency manipulator.” According to the U.S. Treasury Department, China has a history of undervaluing its currency to gain an unfair competitive advantage. 

Since 2014, when the yuan reached an 18-year high, China has been lowering the value of its currency. There are many reasons for that. In 2014, the dollar rose 15% against most major currencies, dragging the yuan up with it. As a result, the yuan was overvalued compared with other trading partners not pegged to the dollar. 

In 2015, the International Monetary Fund (IMF) designated the yuan as an official reserve currency. The IMF required the yuan to be more driven by market forces. As China relaxed controls, the yuan experienced greater market volatility. But the yuan didn’t rise, as many thought it would. It fell, indicating that the market thought the yuan was overvalued.

In 2019, China lowered the yuan’s value. It might have been trying to offset the rising cost of tariffs imposed by President Trump’s trade war. Later that year, the U.S. made its declaration about China being a currency manipulator.

The level of trade is not the only reason the U .S. dollar is the world’s reserve currency. The strength of the U.S. economy instills trust. Most important are the transparency of U.S. financial markets and the stability of its monetary policy. 

On the other hand, Stuart Oakley, managing director of Nomura at that time, pointed out in a 2013 article that China owns $4-5 trillion of unallocated central bank reserves and these could be in yuan. As more bilateral swap lines are set up and China moves further down its path of capital market liberalization, central banks’ appetite to own this currency will grow.

Could China’s ambition to make the yuan the world’s currency lead to a dollar collapse? Probably not. Instead, it will be a long, slow process that results in a dollar decline, not a collapse. 

When the yuan’s value is low, it reduces the prices of many products imported in the U.S. and other countries from China, which can be seen as positive by consumers. The biggest categories are computers, cell phones, apparel, and toys/sporting goods. Low import prices also minimize the threat of inflation. 

But a low yuan value is one reason for the large U.S./China trade deficit. The other reason is that China can pay its workers less than U.S. companies can because China’s cost of living is lower.  China’s demand for Treasurys helps keep U.S. interest rates low. That boosts the U.S. economy by lowering the cost of loans and allowing Congress to increase federal spending. 

China’s peg also influences the value of the U.S. dollar. When China’s central bank sells Treasurys, it lowers the dollar’s value by increasing the supply of dollar-denominated assets.  A dollar collapse won’t likely happen, however, because it’s not in China’s best interests. Selling a big chunk of Treasurys would quickly devalue China’s own remaining holdings. Even so, it’s unwise for the U.S. to allow itself to become so indebted to any other country.