Currency manipulation is nothing new. It has been taking place since the advent of money as a medium of exchange between different nations. Let’s look at the basic Economics 101 course on what currency manipulation generally means and how it influences foreign exchange rates.
Concept One: Foreign exchange takes place when two countries trade together. Country A buys and sells goods from Country B, and vice versa. The problem is, each country uses a different currency. For example, the United States uses the dollar, and China uses the yuan. So if the United States wants to trade with China, it has to convert our dollars into yuan. Sounds simple enough, so what’s the big deal? If the two currencies were equal in value, one dollar would get you one yuan. However, that is rarely the case. For numerous reasons which we will get to, if the yuan somehow becomes worth less than the dollar, it is considered “devalued” and has less buying power in the United States. For instance, if now the dollar is worth $1 and the yuan is worth $.50, it has been devalued by 50% against the dollar in our example. When the dollar and yuan where of equal value, trading between the two nations would be the same. However, as in our example, if the yuan is devalued by 50%, that means that now, instead of getting 1 yuan for each dollar, the U.S. will get 2 yuan for each dollar. What does this mean? Simply, when the yuan is devalued, Americans can buy twice the amount of goods in China.
Concept Two: Tariffs and the effect of monetary policy on currency manipulation. A devalued yuan would make Chinese goods cheaper for American customers. If proposed tariffs were eventually put on imports from China, the devalued yuan would offset, or at least mitigate, the effect of tariffs slapped on imports.
Several factors affect foreign exchange rates in this regard. One is monetary policy instituted by a countries central bank. In the case of the United States, that would be the Federal Reserve. The Fed has several tools at its disposal to effect monetary policy, but by far the most utilized is raising or lowering the federal funds rate, which is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight. Okay, so what. Well, higher interest rates draw more investors to dollar-denominated products, thus increasing the demand for the dollar. The higher interest rate makes that currency more valuable. Investors will exchange their currency for the higher-paying one.
So why are we talking about this now? President Trump alleged during his campaign that the Chinese government was devaluing the yuan. As illustrated above, we can see the deleterious effects that can result from an artificial devaluation. The U.S. Treasury said in a semiannual report Friday that no major U.S. trading partner met the qualifications for being labeled a currency manipulator. China remained on the Treasury’s “monitoring list” for currency practices and macroeconomic policies. The devaluation is not hard to see in the financial markets. Foreign exchange rates, like the dollar and the yuan, are traded constantly around the globe. According to CNBC data, in recent weeks, the Chinese yuan has hit its strongest level against the U.S. dollar since the surprise devaluation of the currency in August 2015. Since Trump took office in January 2017, the dollar has weakened substantially against most currencies, including the Chinese yuan, where the dollar has fallen 8.6%.
The rub is that the average American can understand the basic consequences of tariffs. A tariff is like a tax. It makes something more expensive. Currency manipulation is a subtle, yet sophisticated technique that when used, can be essentially undetected or difficult to prove. In this tit-for-tat between the U.S. and China, it appears that the United States may be taking the high road with tariffs, while the Chinese may be taking the low road with currency manipulation.