This week the Chinese government has allowed its currency, the yuan, to decline in value by about 4 percent against the US dollar. The move has renewed a long-simmering debate about China's exchange rate and whether a cheap yuan will be harmful to the US economy.
In the wake of the 2008 financial crisis, critics faulted the Chinese government for intervening in the market to make its currency artificially cheap. A cheap yuan gave Chinese exporters an advantage in world markets, which critics said was harming US businesses.
Today, the situation is different in an important respect: The Chinese economy is weak while the US economy is strong, which is exerting downward pressure on the yuan. That means China doesn't have to intervene to make its currency cheaper — it can just let market forces push the yuan down.
At the same time, the healthier US economy makes it easier for the US Federal Reserve to counter the harmful effects of a cheap yuan on US exports. So while there were good reasons for Americans to worry about a cheap yuan a few years ago, there's less reason to be concerned today.
I asked Joseph Gagnon, an expert on international economics at the Peterson Institute for International Economics, to help me understand what's happening in China. Here's what I learned.
Currency devaluation is like a nationwide sale
You can think of currency devaluation as a kind of nationwide sale. There are thousands of businesses in China that sell goods and services to customers in foreign countries like the United States. Their goods are generally priced in China's own currency, the yuan. So if the yuan becomes less valuable relative to the dollar, Chinese imports suddenly become cheaper here in America. In other words, when the yuan falls by 4 percent, as it has over the past few days, it's as if every business in China cut its prices for Americans by 4 percent.
And just as sales help stores sell more of their products, a currency devaluation helps countries sell more exports, boosting the economy. Right now the Chinese economy is in the midst of an economic slowdown and has suffered from stock market turmoil, so it can use some extra help.
Chinese devaluation is bad for US exports
Of course, everything I've just said works in reverse for the United States. As the yuan gets cheaper from the perspective of American consumers, the dollar gets more expensive from the perspective of Chinese consumers. That means it's getting more expensive for Chinese people to import American-made goods, so they're likely to import fewer of them. Lower demand for US goods could mean slightly slower economic growth here in the US. (And the same, of course, is true of other countries whose currencies are gaining value relative to the yuan.)
For this reason, people often treat currency devaluation as a "win" for the devaluing country and a "loss" for the country whose currency gets more valuable. That's why Chinese officials have had to defend themselves against criticism from abroad — people outside China worry that further declines in the yuan could weaken economic growth outside of China.
But it's important not to forget that the first-order result of a cheaper yuan is that American consumers pay lower prices for Chinese goods. That's good for American consumers. So if the Fed can offset the negative macroeconomic effects (which it probably can right now — more on that below), a cheap yuan could be good for Americans overall.
China's government used to make its currency artificially cheap, but things are different this time
Most developed countries, including the United States, allow the market to set the value of their currency. US policies can affect the value of the dollar indirectly, of course, but day-to-day fluctuations in the dollar's value are determined by supply and demand for dollars, not by the US government.
China has taken a different approach. Until 2005, the government kept its currency pegged to the dollar, with the central bank buying or selling currency as necessary to ensure that one dollar was worth around 8.2 yuan. Since 2005, the currency has been pegged to a basket of currencies, and the exchange rate has changed over time, but China still actively manages the currency's value on a day-to-day basis.
For much of the past decade, China faced accusations that it was using its control over the currency to make Chinese exports artificially cheap. Especially in the years after the 2008 financial crisis, US critics accused China of using control over its currency to give Chinese companies an unfair advantage over US companies. That was a big deal because in the depths of the recession, US businesses needed all the customers they could get.
But things have changed. Over the past five years, the US economy has been getting stronger, pushing up the value of the US dollar. Meanwhile, the Chinese economy has been getting weaker. The result: The Chinese government no longer needs to intervene in the market to get a cheaper yuan — and the export boost that comes with it. It simply needs to relax its control over the currency and let market forces push its value down.
Still, Gagnon stresses that "the People's Bank of China has complete control over what happens to their currency." If the government had wanted to prevent the yuan from falling, it could have used its vast currency reserves to accomplish that. It chose not to.
China is slowly moving toward flexible exchange rates
In the long run, China hopes to emulate developed economies with fully flexible exchange rates. That's an essential precondition if the yuan is ever to challenge the dollar as the world's reserve currency. However, China has been moving slowly.
"It's like having your dog on a leash," Gagnon says. "Think of a flexible exchange rate as you cut the leash. China's version of it is, 'We'll let another 6 inches of leash out, but it's still on a leash.'"
So while this week's devaluation is a step toward greater flexibility, no one expects China to let go of the leash altogether. If exchange rates move too far in a direction the Chinese government doesn't like, the Chinese central bank will intervene.
A cheap yuan strengthens the case for the Fed to keep rates low
It's the job of the US Federal Reserve to manage monetary policy in a way that provides adequate demand for US companies. The Fed was struggling to do that in 2009. The Fed cut interest rates to zero and took other extraordinary measures — and the economy still performed poorly. In that environment, there was reason to worry that a cheap yuan was contributing to America's economic slump.
But the situation is a lot different today. The economy has been expanding for several years. Indeed, things are going so well that the Fed has stopped debating how to stimulate the economy, and is instead debating how quickly to tighten monetary policy. The central bank ended its aggressive "quantitative easing" policy last year, and is widely expected to begin raising interest rates in the coming months.
This means the Fed is in a much better position to offset the effects of a cheap yuan than it was five or six years ago. If the Fed is worried that weak exports will hurt the US economy, it could delay an interest rate increase that is widely expected to occur later this year.
Gagnon believes the cheaper yuan is "perhaps something the Fed should take into consideration to delay a rate rise."
The weak yuan will change the debate over currency manipulation
The fact that the yuan's current decline is driven by market forces instead of Chinese intervention will also scramble the debate over Chinese currency manipulation. For years, people have been pressuring the Obama administration to fight China's cheap-yuan policy. But the Chinese government doesn't have a cheap-yuan policy anymore — if anything, the Chinese government may be intervening to prevent the yuan from falling even further.
Of course, that doesn't prove that currency manipulation isn't a problem. Other countries manipulate their currencies, and China might go back to making its currency artificially cheap in the future. Groups that have faulted President Obama for failing to get currency manipulation rules in the Trans-Pacific Partnership deal will probably continue advocating such rules.
But China has always been a convenient villain for US currency hawks. Now that the country has stopped pushing down the value of its currency — at least temporarily — critics' arguments will lose a lot of their bite.