China fixes renminbi to soften blow of US tariffs

Depreciating a country’s exchange rate makes exports cheaper and imports more expensive. In order to counteract the 10% tariff on Chinese goods the People’s Bank of China on 5th February set the rate at RMB 7.169 to US$1. This was a similar scenario in the first Trump administration when China allowed the renminbi to depreciate to protect the competitiveness of their exports. How do China authorities intervene to manipulate the Renminbi?

The Renminbi is not a floating exchange rate which it is not determined by supply and demand. The government manages its exchange rate in two ways:

• Peoples Bank of China (Central Bank) can buy or sell US$ on the foreign exchange market – this depends on what they wish for the value of the Renminbi against the US dollar. See explanation below as to how this is done.

• People’s Bank of China permits the Renminbi to trade 2 per cent on either side of a daily midpoint. Basically at 9.15am the Peoples Bank of China (Central Bank) and the SAFE (State Administration for Foreign Exchange) issues a circular to all the trading banks stating that this is the exchange of the Renminbi to the US$ for today. When companies sell goods overseas the US$ etc that they acquire are then exchanged for Renminbi with the Central Bank – therefore the Central Bank accumulates significant amounts of US$.

How does fixing the value of a country’s currency work in theory?

Lets say that the Reserve Bank of New Zealand wants to keep the value of the NZ$ at a certain rate against another currency. The way in which the Reserve Bank of New Zealand can use its funds of currencies to influence the exchange rate can be explained by making use of the diagram below. Let us assume that the value of the NZ$ has been fixed at Pc and, initially, the market is in equilibrium at this exchange rate. The permitted band of fluctuation is Pa to Pb and the value of the NZ$ must be held within these limits.

A large increase in imports now causes an increase in the supply of NZ$’s in the foreign exchange market. The supply curve moves from SS to S1S1 causing a surplus of NZ$’s at the ‘fixed’ rate Pc. If no intervention takes place, the external value of the NZ$ will fall below the permitted ‘floor’ of Pb

The Reserve Bank will be obliged to enter the market and buy NZ$. In doing so that will shift the demand curve to the right and raise the value of the NZ$ until it is once again within agreed limits – Pa – Pb. In the diagram below intervention by the Reserve Bank of NZ has raised the exchange rate to a point between Pa – Pb.

When the Reserve Bank of New Zealand is buying NZ$’s, it will be using up its reserves of foreign currencies; when buying NZ$’s it exchanges foreign currencies for NZ$’s. ‘Supporting the NZ dollar’, that is, increasing the demand for NZ$’s, therefore leads to a fall in the nation’s foreign currency reserves. In the opposite situation where an increased demand for NZ$’s tends to lift the value of the NZ$ above the permitted ‘ceiling’, the central bank will hold down its value by selling NZ$’s. This will increase the supply of NZ$’s and lower the exchange rate. When the Reserve Bank is selling NZ$’s it will be increasing its holdings of foreign currencies.

The main argument for a fixed exchange rate is the same as that against a floating rate. A fixed rate removes a major cause for uncertainty in international transactions. Traders can quote prices which will be accepted with some degree of confidence; buyers know that they will not be affected by movements in the exchange rate. The risks associated with international trade are lessened and this should encourage more trade between nations and more international borrowing and lending.