China's ability to keep the yuan undervalued and the broader sources of its competitiveness

 

MISTRAL.ai  EXPLAINER

How China Keeps the Yuan Undervalued

1.   Currency Market Intervention:

·  The People’s Bank of China (PBoC) actively buys large amounts of foreign currencies, primarily U.S. dollars, using yuan. This increases the supply of yuan in the market, which lowers its value relative to other currencies. Over the years, this has led to China accumulating massive foreign exchange reserves—at one point, nearly $4 trillion.

·  By maintaining a weaker yuan, Chinese exports become cheaper in foreign markets, making them more attractive to international buyers.

2.   Managed Exchange Rate System:

·  China does not allow the yuan to float freely. Instead, it sets a daily reference rate and manages the currency within a controlled band. This allows the PBoC to guide the yuan’s value to support export competitivenesscnbc.com+1.

3.   Capital Controls:

·  China restricts the flow of capital in and out of the country. This prevents speculative inflows that could drive up the yuan’s value and helps maintain its undervaluation.

4.   Gradual Depreciation:

·  Rather than allowing sharp devaluations, the PBoC engineers a gradual depreciation of the yuan, especially during periods of economic stress or trade tensions. This approach avoids triggering capital flight while still supporting exports.

Impact on Competitiveness:

·  A weaker yuan makes Chinese goods cheaper abroad, boosting export volumes and market share. This is particularly important in labor-intensive and manufacturing sectors where price sensitivity is high.

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Other Sources of China’s Competitiveness

While the yuan’s value plays a role, China’s competitiveness stems from several other factors, both structural and temporary:

Structural Factors (Long-Term)

1.      Manufacturing Ecosystem:

·  China has built a vast, integrated manufacturing base with unmatched scale, supply chain efficiency, and infrastructure. This ecosystem reduces production costs and lead times, making it difficult for competitors to match China’s efficiency.

2.   Government Support and Industrial Policy:

·  Subsidies, tax incentives, and state-backed investment in key industries (e.g., electronics, renewable energy, and electric vehicles) have fostered globally competitive firms and technological advancements.

3.   Skilled Labor Force:

·  China’s large pool of skilled and semi-skilled workers, combined with relatively low labor costs, supports high productivity and cost efficiency.

4.   Infrastructure and Logistics:

·  Extensive investments in ports, railways, and digital infrastructure reduce transportation and operational costs, further enhancing competitiveness.

Temporary or Cyclical Factors

1.      Supply Chain Dominance:

·  China’s early and aggressive response to the COVID-19 pandemic allowed it to maintain production while other countries faced disruptions, temporarily boosting its market share.

2.   Energy and Raw Material Costs:

·  Access to affordable energy and raw materials, sometimes at state-controlled prices, has historically kept production costs low.

3.   Global Trade Dynamics:

·  Trade tensions and tariffs (e.g., U.S.-China trade war) have led China to diversify markets and adapt production, sometimes offsetting the impact of a stronger yuan or higher tariffs.

4.   Technological Catch-Up:

·  Heavy investment in R&D and technology transfer has allowed China to move up the value chain, producing higher-tech goods and reducing reliance on low-cost labor alone.

5.   Economies of Scale:

·  The sheer size of China’s domestic market allows companies to achieve economies of scale, lowering per-unit costs and increasing global competitiveness.

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Summary: While keeping the yuan undervalued provides a competitive edge, China’s dominance in global trade is underpinned by a combination of structural advantages (manufacturing ecosystem, infrastructure, labor force) and temporary factors (supply chain resilience, state support, and energy costs). The yuan’s value is just one tool in a broader strategy that includes industrial policy, infrastructure, and innovation. Over time, as China’s economy matures, the relative importance of currency manipulation may decline, but its structural strengths are likely to persist.