The big news over the weekend was that China announced they will allow its exchange rate to be more flexible and allow market forces to play a greater role in setting its value.  The move was likely made in part to please the Group of 20 (G-20 includes finance ministers and central bank governors from 20 economies around the world), which is set to meet June 26.

China pegged its currency to the U.S. dollar in July 2008 as an “emergency setting,” but it had become increasingly obvious that this was no longer necessary.  China was likely to receive an earful at this week’s G-20 meeting, especially after their May exports report showed a nearly 50% surge from a year ago and restored China’s monthly trade surplus above its five-year average.  Despite the new flexibility, China’s cryptic statement on Saturday implied they have no intention of letting the value of the yuan (also referred to as the renminbi) gain too much.

China manipulates its currency by buying up dollars, but I’d guess most readers don’t understand how this works.  Today I hope to present you with a simple example that will make you all currency experts. 

Consider a U.S. manufacturer that wants to build a factory in China to capitalize on the country’s growth.  To build the factory, the manufacturer will need Chinese currency because that’s what people use in China.  In order to do that, the manufacturer buys Chinese yuan from a Chinese bank and sells dollars. (Pretty easy so far, right?)

If the yuan were a free-floating currency, this exchange would increase the value of the yuan.  But a lot of other companies are excited about China’s growth prospects and they too want to build factories there.   The cumulative impact of all those inflows of dollars would be to drive the value of the yuan higher – if it were a free-floating currency.   But it’s not.  It’s pegged to the U.S. dollar. (“Huh?” you say.)

Here’s how it works.

China has strict rules about what kind of capital banks can hold.  So in our example, the bank where the U.S. manufacturer changed dollars into yuan is required by law to give those dollars to the Chinese central bank.  The central bank then pays for those dollars with yuan.

But where does the yuan used to pay the banks for U.S. dollars come from?  The central bank prints them.  Just like the Fed does with quantitative easing, China prints whatever amount of yuan needed to buy up any amount of dollar inflow into the country.

The rate of yuan per dollar is announced every morning at 9:15AM Shanghai time, which is 9:15PM the prior day U.S. Eastern time.  On Monday, the exchange set by the People’s Bank of China (PBOC) was 6.8275 to the dollar.  The yuan’s value, which China only allows to increase or decrease 0.5% on a daily basis, increased 0.5% yesterday.  Yet today, the exchange rate was set at 6.7980, or 0.43% higher than Monday’s exchange rate. 

The fact that the exchange rate was set below yesterday’s market price confirms my earlier point that has no intention of letting their currency appreciate freely.  But it’s a step in the right direction for China.

And now you are a currency expert.  Later this week I will have a post later this week about the effects of China’s policy decision on the global economy.

Thanks for reading.

Peter Lazaroff, Investment Analyst

www.acrinv.com