What is the most influential thing humanity has ever created?
Some will say it’s the wheel or the computer, but let’s face it. It is the system of money. Look around you, there is money involved everywhere; every object in your house is the result of a transaction that you’ve made. And when we talk about money, perhaps its most visible component is currency. Currency in the simplest of terms is a medium for a transaction to take place, may it be physical or virtual. Having understood that, let’s talk about the bigger picture. Have you ever wondered why so many products say ‘Made in China’ on them? It is all related to a game of currency. Donald J Trump, the President of the United States of America has often accused the People’s Republic of China of ‘currency manipulation’.
That brings us to an important question: If a currency is only a medium to perform transactions, how can a state ‘manipulate’ it and even benefit from it?
Open vs Closed Economy
Before we look to answer that question, we must understand a few basic concepts of economics. Every open economy has two components, import and export. They together make up what we call the overall trade. A few countries have closed economies in which they prefer to keep themselves ‘self-sustainable’. However, almost all states form a nexus of connected economies, where the functioning of one often affects the other. This trend is referred to as Globalisation. Moving on, there is a simple reason why an open economy is preferred over a closed one. It is because the cost of production in every country is not the same. Let’s take up an example to understand this well.
Bob and Sam Explain Through Lemon Stalls
Two hypothetical people Sam and Bob run lemonade stalls. Sam buys lemons whereas Bob has his own lemon orchard. In the best case scenario, Bob’s lemon produce meets all his needs and he manages to run his stall on a much lower capital investment as compared to Sam. However, there is one downside to Bob’s stall, that is the amount of time and effort it requires. Sam simply goes and buys lemons from the market whereas Bob grows his own, looks after them, harvests them and then uses them, but for a greater amount of money. Seems perfectly alright. However, we considered the best case scenario.
Now let’s assume that both their businesses expand, and now they open a chain. Bob, still reluctant to open up his business, expands his orchard and hires a workforce to help him better manage the produce. Add to that his already existing employees to manage the chain itself. We see that Bob now has a higher capital investment as compared to Sam, but can still be justified by the fact that his profit is more. But the problem arises when we compare the profit percentages in both the businesses. We observe that Bob and Sam have similar profit percentages, assuming that they have proportional expenditure and income. Although Bob earns more, he also spends more. Analysing this, it appears that maybe it isn’t a great idea to do everything by yourself because directly buying specialized goods or services can indeed be cheaper. That brings us to another important concept: trade.
As seen above, we need to trade to satisfy our demands or expand our own enterprise. Importing and exporting is preferable because it helps balance the system, with the surplus being exported to states that are in need.
Net exports are defined as the difference between the value of total exports and the value of total imports. If this value turns out to be negative, it is said to be a trade deficit, implying that a country imports more than it exports. In 2016, the total U.S. trade deficit was $502 billion and is expected to increase by the end of this fiscal year.
Let’s look back at our example; assume that either Sam or Bob spend more than they earn. This can work if they already have sufficient funds with them or if it is only a one-time investment. However, if they continue to spend more and more with little earnings, they start losing more money than they earn. this example applies to real life problems, in particular, what the US faces currently.
Now to keep trade in balance, two things can be done: Either the US can sell its assets or take loans. The US has had a policy of taking loans over the years. They currently owe roughly $20 trillion, the most in the world. For obvious reasons, this negatively impacts the economy. This is the current situation of the US economy.
China And Currency Devaluation
Enter China. China has had a policy of devaluing their currency. Devaluing a currency means reducing the value of a currency when compared to a foreign currency. Let’s assume that $1 is equal to 1 Yuan. If China devalues their Yuan, now that $1 is equal to 3 or 4 Yuan.
The result? The USD grows stronger in the world economy. This means that the dollar can now buy you more than it could than before because now its value is increased. This benefits Americans in other countries as tourists, because they can buy more foreign goods for lesser cash. This also means that the imported goods in the US are cheaper, and the average American seems to largely benefit.
The dollar is now stronger, relative to the rest of the world. Take a basic example. Let’s assume that a certain product costs $50 to produce and is exported for a value of $100 to a foreign state, say India. This product costs roughly around 7000 rupees in India. However, when the dollar becomes stronger, it requires more INR (Indian Rupee) to buy the same product. This implies that the product now costs more than 7000INR, and now lesser people can afford it. Lesser sale leads to a lesser demand and a lesser overall export for the US. Now keep in mind the already huge trade deficit of the United States along with the debt burden mentioned above.
Because the USD is now stronger, it is more expensive for a foreigner to import goods from the US. This directly means that the Foreign Direct Investment or the FDI is affected. Now lesser foreign companies set up their businesses in the US and understandably, lesser manufacturing takes place in the US. This further reduces exports and increases the trade deficit.
But what does China get from all of this?
The reason is simple; it attracts manufacturing industries. China had a high unemployment and a high poverty rate around the 1980s. The government introduced many policies to curb this. One of the extended policies of their ideology was to create a manufacturing hub in China. Currency devaluation helps them do this. Because the Yuan is now valued much lower, it is easier for foreigners to set up their businesses here. They can produce more for a much lesser cost.
In fact, it costs lesser to produce in China and then ship it to the US, than it does to produce in the US. This is why most goods are produced in China and then shipped around the world. Is this wrong? The World Trade Organization or the WTO says that export subsidies are considered a negative trade practice and an unethical method of gaining competitive advantage. However, no internationally recognized body has taken any action against this yet.
The Flip Side of Currency Manipulation
There is a major downside to this Chinese policy: Standard of living. The citizens of China now suffer more because their currency isn’t strong and they cannot enjoy foreign goods because they cannot afford it. Their position in the global community is reduced, although a lot of employment is created in their country. It also makes it very tough for local businesses to compete because of such heavy intervention of the Chinese Central Bank. The average Chinese citizen suffers.
The Chinese Central Bank buys a lot of dollars from the international market to reduce the amount of currency in flow. Lesser the currency, more the demand. Increased demand leads to increased value. But what does China do with these dollars? China buys US Treasury Bonds. They offer the safest form of forex reserves. The Chinese Central Bank also intervenes largely within China to take the excess dollars in circulation and give the exporters the required Yuan. This creates a scarcity of USD and maintains its high value even within the country.
That brings us to perhaps the conclusion of a rather interesting situation at hand. With the President of the United States accusing China of stealing millions of jobs, the coming days offer a lot of perplexing debate and surprising policies. Do read America’s Biggest Organisation: Discrimination.