Recently China allowed their currency to fall below the key level of 7 yuan per dollar. But what does that mean for a currency’s value to change? And what benefit does China gain from this move?
Before we can really answer that question, we need to understand what it means for a currency’s value to change – and how a currency valuation impacts the global economy. In today’s world currencies are free-floating – which just means that the value of currencies relative to each other can change. It wasn’t always this way. Under the old gold standard currencies would all be convertible into gold. And after World War II, the Bretton Woods Agreement established fixed exchange-rates with currencies pegged to the dollar. But after that system broke down, nations abandoned the peg to the dollar and floated their currencies.
Purchasing Power Parity
With currencies now floating, the relative value of a currency suddenly mattered. Under the current free-floating monetary system, the prices of currencies themselves can be manipulated – which affects the calculation of comparative advantage for trade. Currencies can be undervalued or overvalued relative to each other. One might logically suppose that when six Turkish Lira can be exchanged for one American dollar, the actual purchasing power of one dollar would be roughly the same as six Turkish Lira. In other words, if a cheeseburger cost $5 in the United States, when you exchange currency you may get ¥500 yen, but a cheeseburger in Japan should then cost roughly ¥500 yen. But this is not the case. Many nations manipulate the currency exchanges to undervalue the purchasing power parity (PPP) of their own currencies. Making everything priced in their currency cheaper to buyers from foreign countries. This is the reason that China purchased so much U.S. government debt – China bids up the price of the dollar relative to the yuan by buying dollars with yuan, and then sits on these dollars by purchasing U.S. treasuries with them. This is why the idea that you sometimes hear that China could hurt the U.S. by selling off their treasury holdings is totally backward. If they sold their dollar denominated U.S. debt for yuan the value of the yuan would spike and deeply damage their export economy. Both Donald Trump and Elizabeth Warren want the dollar to be weaker because, as we will see, a weaker currency will boost exports.