Why does keeping a foreign currency reserve ensure that the value of domestic currency stays lower than that foreign currency?


“China pegs the value of the yuan to the US dollar. By stockpiling dollars it raises the dollar value versus the yuan thereby increasing sales by making Chinese exports cheaper than American-made goods.” But why exactly does stockpiling dollars raise the dollar value versus the yuan? Why does it make the yuan less?

In: 14

They buy USD using RMB. This drives up the demand for USD, increasing its value, while simultaneously devaluing the RMB, as the supply of it on the market is increasing.

If they didn’t stockpile the USD (ie, they just sold it later), then the supply of USD on the market would go back to where it was before they bought the USD.

When someone buys a Chinese made good, they send dollars to a business in China. That business doesn’t want dollars it wants yuan to pay its employees and suppliers. So it sells dollars and buys Yuan. That over time should lower the price of the dollar relative to the yuan, but the Chinese central bank buys dollars and sells yuan raising the price of the dollar and lowering the price of the yuan.

This means the central bank piles up dollars it can’t sell, which usually are invested in dollar assets like bonds or real estate or equities.

1. Supply and demand. Currency markets (USD, Euro, RMB, etc) are subject to supply and demand like oil and food are. China buying USD using RMB increases the supply of RMB (depressing its value) and decreases the supply of USD (increasing its value) on the market.

2. It offsets the trade imbalance. The US imports far more from China than China does from the US. If the Chinese government did not buy USD or US bonds, it will cause the RMB to increase in value (US buys Chinese goods in RMB, increasing RMB demand) relative to the USD.

This essentially means the Chinese government HAS to buy USD and US securities (like US treasury bonds) to keep their price advantage. Otherwise, it would increase the value of the RMB and make Chinese manufactured goods more expensive, which would drive down demand for Chinese goods abroad. China holds a lot of US government debt. Despite Reddit logic, this is good for the US and bad for China. It gives the US far more power over China than China has over the US. China literally can’t sell those bonds (or USD reserves) without utterly destroying their own economy. Especially in today’s economy where the EU, China’s other large trading partner, is doing particularly bad.

You see this dynamic in all of the US’s trading partners. Japan for example used to be the largest foreign holder of US treasury bonds before China overtook them precisely because of their massive economic boom pre-90’s where they exported a lot of goods to the US. It’s the only way for them to stay counter the effects of the trade imbalance. This is also why people complaining about the trade imbalance in US politics don’t understand anything about economics. It’s a set of golden shackles on trading partners, and the US holds the keys.