Why Does China Want to Lower the Value of Its Currency?

The U.S. Labels China a Currency Manipulator

On August 5^th, 2019, the U.S. Department of the Treasury designated China as a ‘currency manipulator’. China has been on the U.S.’s watch list for quite some time. The U.S. believes that China “engaged in persistent one-sided intervention in the foreign exchange market”. So the U.S. is requesting that the International Monetary Fund (IMF) “eliminate the unfair competitive advantage created by China’s actions”.

Why would China want to keep the value of its currency artificially low?

How Currency Exchange Rates Affect Businesses

Currencies are constantly changing in value against other currencies. This is based on a variety of factors including the country’s inflation rate, interest rates, balance of payments (i.e. whether they are a net importer or exporter), government debt, economic health, and political stability. But through the Forex markets and other mechanisms governments can also work to artificially affect the value of their currency. Currency appreciation/depreciation happens when a nation’s currency (e.g. the US dollar) changes in value in comparison to other country’s currencies. For example, if the dollar increases in value, it will purchase more than it previously did when converted to another currency. (Whether or not purchasing power changes at home.) This means that a business can buy more for their money from an overseas supplier. However, if it decreases in value, overseas expenses will increase.

The Biggest Benefits of Currency Depreciation

Currency depreciation isn’t always bad for businesses. The major factor is whether they are primarily an importer or an exporter. In fact, it can positively impact companies who primarily sell to foreign buyers (i.e. net exporters). By lowering the value of the Yuan, China hopes that it will make their products cheaper in foreign markets. This gives them a competitive advantage and in effect cancels out any tariffs imposed by the U.S. (i.e. tariffs raise the cost of an import but depreciating foreign currency lowers the cost).

If China’s costs (labor and materials) are all denominated in Yuan, expenses may not increase in the short run. And they hope the volume of sales from outside the country will increase thus increasing profits.

Tourism might also increase following currency devaluation. Overseas travelers will view a nation as a more affordable destination. Since they get more local currency for their money when they convert their money. As a result, popular tourist destinations might experience increased visitors. This can financially support stores, restaurants, bars and other businesses during a tough economic period.

Importing Issues

On the other hand, companies whose primary expenses are denominated in a foreign currency will be at risk during currency devaluations. China is a net exporter, and the largest export economy in the world, so devaluing the Yuan makes sense. In 2017, China exported $2.41 Trillion worth of goods, while importing $1.54 Trillion, giving them a positive trade balance of $870 Billion. So although devaluing the Yuan would help exporters it would simultaneously hurt importers, as their costs would increase since it would take more Yuan to buy each item.

However, much of China’s imports are actually components for export items. 13% of China’s imports are made up of integrated circuits, 9.4% is Crude Oil, 3.8% is Iron Ore, 3% is Cars and 2% is LCDs. Industries, that import resources like LCDs and integrated circuits (that they then use to produce their products) will get squeezed by the currency devaluation. The impact the exchange rate will have on an organization is determined by various factors. For instance, if a company imports raw materials and only sells them to the domestic market, they will lose money due to currency depreciation. However, much depends on the balance of their import costs vs. their export revenues.

The best scenario occurs when a company’s costs are denominated in the depreciated currency and their income comes in the appreciated currency. This can drastically improve profit margins. Other combinations have varying effects. The worst combination is when expenses are denominated in the appreciated currency and income is denominated in the depreciated currency.

Effects of a Trade Surplus

When China receives a trade surplus, they must find places to invest that surplus, so often they target a foreign nation’s businesses for merger and acquisition attempts. They also invest the surplus in U.S. debt such as Treasury Bills and Notes. Depreciating local currencies can increase their desire to invest in other currencies and businesses as a form of diversification.

An Indirect Impact

Even if an organization doesn’t buy from or sell products to other countries, it is likely the current global economy will still impact the business. As in China’s example, the foreign exchange rate can increase the price of imported fuel, natural resources, and electronics. Foreign interest rates can also negatively affect an organization. For instance, if you are required to make loan interest payments to an overseas party, it is possible you will need to make the repayments in their currency. Unfortunately, it will cost your company more money to convert into the stronger currency, which could impact your bottom line.

In the Long Run

A weakened currency can lead to businesses and consumers suffering from higher rates of inflation. Higher Tariffs (import fees) lead to higher prices for imported products. Trade barriers can help businesses to survive during a difficult economic crisis, in the short-run. But, in the long-run, it is the customer who will face the financial burden, which can lead to them reducing spending which can snowball into other recessionary forces.

Mitigating Risk

Government policies including those regarding the exchange rate can impact businesses of all sizes in a variety of ways. An individual company’s circumstances will ultimately determine whether they make it through an arduous financial climate or not. Thankfully, there are ways organizations can protect themselves from exchange rate fluctuations. For example, they can use fixed contracts when buying imported raw materials, which will allow them to enjoy a set price for their imports for between 12 to 18 months, thus shifting the risk to the seller. They can also hedge currencies through the Forex market.

If a business is already battling with financial issues, such as rising overheads or compensation expenses due to exchange fluctuations any additional stress could signal the end of your enterprise. Therefore, organizations plan for ways to mitigate all sorts of risks. Businesses typically hedge against currency risk through the Forex market. They also purchase business insurance, which will cover them if they are sued. There are a variety of different types of insurance coverage including general liability which covers accidents at work, including property damage, physical injury, and medical or legal fees. There is also Professional Liability insurance which covers accusations of professional mistakes, and Worker’s Compensation which covers injuries to employees. Taken together with “currency risk insurance” through wise Forex hedging a company can limit its risk to an acceptable level.

In this case, a U.S. company using Chinese components would probably benefit from a devalued Yuan but that is not always the case and companies must be ever vigilant for situations that could spell disaster.

You might also like:

About Tim McMahon

Connect with Tim on Google+.