How China Influences the U.S. Dollar

By Kimberly Amadeo  Updated July 09, 2019

China directly affects the U.S. dollar by loosely pegging the value of its currency, the yuan, to the dollar. China's central bank uses a modified version of a traditional fixed exchange rate that differs from the floating exchange rate the United States and many other countries use.

The People's Bank of China

The People's Bank of China manages the yuan's value. It keeps it fixed to a basket of currencies reflecting its trading partners. The basket is weighted toward the dollar since the United States is China's largest trading partner. It keeps the yuan's value within a 2% range against that currency basket.

On August 11, 2015, the PBOC modified this peg. The change uses a "reference rate" that is equal to the previous day's yuan closing value. The PBOC wanted the yuan to be more driven by market forces, even if it meant greater market volatility. The International Monetary Fund (IMF) required the PBOC to make the change. It was necessary before the IMF would consider the yuan an official reserve currency.

As of October 23, 2018, the U.S. dollar was worth 6.94 yuan. This valuation means that China's central bank guarantees it will pay 6.94 yuan for every U.S. dollar that a holder redeems.

Why China Fixes the Yuan's Value to the Dollar

China manages its currency to control the prices of its exports. It wants to make sure its exports are reasonably priced when sold in the United States. Every country would like to do this, but few have China's ability to manage it so well.

China's command economy allows it to control the central bank and many businesses. As a result, the Communist Party directs China's economy. The U.S. government regulates exchange rates instead of managing them.

How China Manages Its Currency

China's currency power comes from its many exports to America. The top categories are consumer electronics, clothing, and machinery. Also, many American companies send raw materials to Chinese factories for low-cost assembly. The finished goods are considered imports when the factories ship them back to the United States. That's how the U.S. trade deficit with China is profitable to American companies.

Chinese companies receive dollars as payment for their exports to the United States. The firms deposit the dollars into banks. In return, they receive yuan to pay their workers. The local banks then send the dollars to China's central bank, the People's Bank of China. It holds them in its foreign exchange reserves.

By stockpiling dollars, the People's Bank reduces the supply of dollars available for trade. It puts upward pressure on the dollar's value, lowering the yuan's value.

To continue reading, please go to the original article here:

https://www.thebalance.com/how-does-china-influence-the-u-s-dollar-3970466