Skip Montreux examines the relationship between the Chinese Yuan and U.S. debt
My name is Skip Montreux and this is Down to Business English.
Welcome to the program. Today I’m reporting from Tokyo with Part 2 in Down to Business English’s series on the Foreign Exchange Market, or Forex for short.
Last Episode, Dez explained the basics behind Forex trading. Today, I will be taking a close look at a real world example of some of those fundamentals in practice. Specifically, I will be examining how the Chinese government controls it’s currency, the Yuan, and the delicate relationship between the value of the Yuan and the US economy.
This is a very interesting topic and one well worth understanding, regardless of the industry you work in.
Let’s get D2B….Down to Business with The Chinese Yuan the, U.S debt and a lesson in economic co-dependence.
As Dez explained in the last episode, one of the most basic or fundamental factors that affect a currency is supply and demand. The greater the supply of a currency, the lower its value. The greater demand for a currency, the higher its value.
To see this effect in action on a freely traded currency, you only need to look at the Japanese Yen through the 1970s and 1980s. As the United States bought an increasing amount of Japanese made products, they needed to purchase greater quantities of Yen. The more Yen the United States bought, the more it was in demand. And the more the Yen was in demand, the more it rose in value. Just compare the strength of the Yen between 1971 and 1995. In 1971 it took 360 Yen to buy an American Dollar. By 1995, it only took 100 Yen to buy that exact same dollar.
Applying the principle of supply and demand to U.S. trade with China, one would expect a similar effect. The United States, in order to purchase goods from China, would use American dollars to buy Chinese Yuan. As more and more Chinese products are purchased, the demand for the Yuan should grow, and the value of the Yuan should appreciate. At the same time the value of the U.S. dollar should decrease because more of it is now in circulation. In a free market, this is what should happen. But it doesn’t. Even though the United States imports an extraordinary volume of goods and products from China, the value of the Chinese Yuan is not increasing.
Why is this? Why isn’t the Chinese currency rising as their exports rise?
One reason is the Chinese government doesn’t allow their currency to be traded freely on the international market. In fact, they even go as far as limiting the amount that can be exported by individuals. For example, citizens traveling abroad are only allowed to take a limited amount of Yuan with them.
Another and even more concerning reason is the Chinese government buys a huge amount of dollar denominated assets to avoid repatriating its currency and raising its value. Let’s look at a hypothetical example to illustrate this point.
Chinese company X sells a product to a US retail chain. The retail chain pays for the product in U.S. dollars. You would now expect the Chinese company to exchange those U.S. dollars for Chinese Yuan in order to repatriate the profits. However they don’t. The transaction remains incomplete as the U.S. dollars paid to the Company don’t get exchanged into Yuan. Instead, Company X takes those U.S. dollars and buys U.S. government bonds. By doing this, Company X avoids repatriating its profits, which helps keep the demand for the Yuan low keeping the value of the currency low, which in turn keeps Chinese exports at an attractive low price.
This hypothetical example is in fact not very hypothetical. It is because of this exact practice that China today owns more U.S. government debt that any other country and they keep adding to their already huge position. To make matters worse, since 2002, to avoid appreciation of its currency, China has sold 2.17 trillion dollars of Yuan to invest in the United States.
It is important to understand that for a long period of time, this seemed like a complimentary relationship. The U.S. was in debt and needed money. China needed to keep its economy growing to provide employment to its expanding manufacturing sector. By buying American government bonds China helped the U.S. pay for its debt while at the same time was able to keep the value of the Yuan low and keep its exports cheap and attractive.
However since the global economic crisis has set it, some companies in the U.S. have become increasingly unhappy with this relationship saying that it gives the Chinese companies an unfair advantage in the market place. They complain that they can not compete with the inexpensive products coming out of China.
Is this true?
Well-yes, probably. But as with most international trade disputes there are two sides to the debate. The Chinese position is that they need to keep their currency stable through the economic crisis and are working to do so through intervention. China also feels that many of the attacks coming from the America are caused by an increase in U.S. protectionism.
Are these accusations true?
Again, yes- probably. President Obama is under great pressure from individual states to protect American workers and jobs and the Chinese do make a convenient target for this growing resentment. Some listeners will probably remember similar emotions directed towards Japan in the 1980s and early 1990s. Japanese companies at that time were seen as unfairly competing with U.S. firms. However, as China is now the largest owner of U.S. debt, the U.S. has to be very careful in its negotiations.
China has the ability to devastate the US economy by simply stopping buying its debt. If the Chinese stopped buying up U.S. debt the U.S. would then need to find another lender. Another lender would be sure to demand a higher interest rate in return for the loan. Remember, the Chinese are buying dollar-denominated assets to keep their currency cheap, not because it is a good investment. A 10-year US bond only has about a 3% rate of return after all.
So what is the likely outcome?
As the value of China’s currency is set by a soft peg to the US dollar, the most probable outcome is the range of this peg will be widened. If you remember from last episode, a soft peg is where currencies trade in a controlled range compared to a hard peg where the value is set. A daily range of up to 3 per cent has been suggested by some theorists and a figure around this value seems likely. By allowing the Yuan to trade within a wider range the U.S. will see its products become more competitive and China will still have some control on the rise of the Yuan.
This entire issue is very much a double edged sword. On one hand America is unhappy that it is so difficult to compete against inexpensive Chinese products, but on the other hand, America’s high standard of living is directly related to China financing their debt. As a final point to the story, the main message coming out of Beijing on this issue is that they are in no hurry to make changes to the situation. They have no intention of doing anything that would damage its current economic growth figures regardless of the political landscape in Washington D.C or the wishes of the Obama administration. Whatever does happen, it will certainly have an effect on the entire global economy.
Now that we have examined the relationship between the Chinese Yuan and U.S. debt, let’s go back and take a closer look at some of the key words and phrases in the story. Let’s get D2V….down to vocabulary.
To start things off today I want to talk about two related words. They are currency and denomination. We use the word currency to talk about the kind of money used in a country. The currency of China is the Yuan, the currency of the United States is the U.S. dollar, the currency of Japan is the Yen, and so on. Now the word denomination is used to refer to the different amounts a currency is available in. For example, here in Japan the Yen is available in 4 denominations: the ¥1000 note, ¥2000 note, and the 5 and ¥10,000 notes. In the story I use the phrase U.S. dollar denominated asset which simply means something that must be bought with U.S. dollars.
Okay, next is the verb to appreciate. I am sure everyone is familiar with the English phrase “I appreciate your help.” It is a polite way to say Thank you. Another way this word is used, especially in business, is to communicate that something is increasing in value. For example, shares in the company appreciated 12% last year. This means that stock prices have gone up or increased 12%.
Moving on I would now like to talk about the word circulation and its verb form to circulate. This is a very useful word and can be used when you are talking about something that is moving around. It’s interesting that the root of circulation is the same as the word for ‘circle’ and that is a good way to remember it. Anything that moves around and around and around, is circulating. In today’s story, I talk about U.S. dollars decreasing in value because more of them are in circulation- more of them are moving around in the economy. Other examples are: blood circulates through our body, air circulates through the room. And as a noun; the circulation of newspapers and magazines has been decreasing recently due to popularity of the internet. Circulation, a very useful word
Another key word from today’s story is repatriate. It is a variation of the word patriot. If you check the word patriot in your dictionary, you will learn that a patriot is a person who will strongly defend their country, even go as far as giving their life. Patriotism is a strong sense of love or devotion to one’s home country. An expatriate is a person who lives outside of their native country. As you can probably guess by now, repatriate has something to do with one’s country. To repatriate something means to return something to its home country. Here is an example; after living in Japan for 10 years Dez Morgan was repatriated to the United Kingdom.
Next is the word hypothetical. This is an excellent English adjective that comes to us from the world of ancient Greek science and medicine. It is similar in meaning and use to the adjective ‘imaginary’. But whereas something that is imaginary is unbelievable, such as a child’s imaginary friend. Something that is hypothetical is is based on reality. In the story I talk about a hypothetical Chinese company. I am not referring to a real company but rather an imaginary company. Hypothetical is also often used in the expression ‘hypothetically speaking’. For example; Hypothetically speaking China could destroy the U.S. economy by selling all the American bonds they own. This sentence communicates that is possible for this to happen but extremely unlikely.
Now I would like to talk about the word dispute. Dispute is commonly used both as a noun and a verb. A dispute is situation where two parties disagree with each other. Here are some examples; Japan and Russia have been disputing the ownership of the Sakhalin islands for the past 40 years. Or; There was a dispute in the meeting about when the company should release its latest product. Half the members want to release it in the Spring, the other half want to wait until Summer.
I’m going to finish today with the idiom a double edged sword. This idiom is used to describe a situation that has both good and bad effects. For example, last year I received a promotion at work. With the promotion came both higher salary but much more work and much more responsibility. I could say, the promotion really was a double edged sword.
Okay those are our key words and phrases today. Please go back, listen to the story again.
This brings us to the end of another episode of Down to Business English. Remember, you can download the audioscript to today’s show from our website at www.downtobusinessenglish.com . One more time, that’s www.downtobusinessenglish.com . Also, if you are enjoying this podcast or finding it useful, both Dez and I would very much appreciate it if you could tell your friends and colleagues where to find us. You can send them to the website or tell them to search for us in the iTunes Music Store.
Thanks again for listening. Goodbye everyone. Talk to you next time.