Plumbing the depths of currency controversies

Two economics professors provide insights into currency controversies: Claims that China and Japan manipulate their currencies to keep them weak to help their exports; and what it would mean if China's yuan were to become a reserve currency.

Some in the United States Congress have long sought to curb what they claim is currency manipulation by China. The "undervalued" currency makes Chinese exports artificially cheap, they say, and contributes to the large US trade deficit with China.

China's accumulation of large US dollar reserves is seen as evidence of such "manipulation". That is, China keeps the dollar strong - and hence, the yuan weak - by consistently buying dollars and investing mainly in US Treasuries (government bonds issued to fund the US budget deficit).

The strong US dollar/weak yuan benefits American importers and business and household consumers who enjoy cheaper Chinese goods, but hurts US businesses and workers who compete with Chinese products.

Fact: The yuan has been steadily appreciating against the US dollar since 2003, and even last year when the dollar soared against most other currencies.

Together with higher inflation in China, this allowed the International Monetary Fund (IMF) to declare that the currency is "no longer undervalued".

Functioning as a reserve currency does not come from a formal status bestowed by the International Monetary Fund, but must be earned through winning the trust and confidence of private market participants as well as foreign governments. In China's case, the need to reduce state control and depoliticise domestic financial institutions will be a particular challenge. PHOTO: REUTERS

Congressional accusations of currency manipulation are now directed at Japan, whose currency has plunged more than 30 per cent against the dollar since 2013.

This is a major reason given for opposing the proposed Trans-Pacific Partnership (TPP) regional trade agreement - which includes Japan, and Singapore, but not China - because the agreement does not contain sanctions against currency manipulation.

The US auto industry, in particular, fears competition from Japanese carmakers whose cost advantage is greater when the yen is weak. (They did not complain in the many years when it was strong).

Fact: The yen's recent weakening is due to Japan's monetary stimulus to counter domestic deflation and stagnation: anticipated rising inflation at zero nominal interest rates has reduced its attractiveness to investors, who are now more attracted by renewed growth in the US economy. Monetary stimulus is also under way in the euro zone, weakening the euro, but the Europeans are not being accused of currency manipulation.


The IMF forbids countries from "manipulating" their currencies to gain an "unfair trade advantage" by depressing a currency's value to make exports less expensive for foreign buyers, and imports more costly for domestic buyers.

But currency manipulation is difficult to prove since it is indistinguishable from cutting interest rates to stimulate a domestic economy (by making it cheaper to borrow to spend and invest). The IMF also lacks an enforcement mechanism.

The World Trade Organisation (WTO) allows countries to retaliate against specific "illegal" export subsidies by a trading partner, but does not explicitly cover currency manipulation.

The claim of currency manipulation is warranted only if a central bank simultaneously restricts the purchase or sale of foreign currencies and buys foreign currency assets, thereby significantly increasing its holdings of foreign monetary assets or "international reserves".

Fact: Exchange rates are relative. A major factor behind the recent weakening of the yen and euro is the strengthening of the US dollar - which is the result of stronger US growth and the imminent raising of US interest rates, both of which will make holding dollar assets more attractive for investors.

But the strong dollar also makes US exports more expensive and foreign imports less expensive. This is the very same outcome for which China and Japan are accused of manipulating their currencies.


A "reserve currency" is any foreign currency whose assets monetary authorities are willing to hold as a store of value. How much they hold depends on anticipated future demand and supply of that currency. Thus a country's monetary authority cannot unilaterally decide to "internationalise" its currency. It can only discourage others from holding assets in its currency, as Singapore and Switzerland do.

The currency must be widely used, so is likely to be from a large economy engaged in lots of trade and investment with many other countries. It must be fully convertible - holders of the currency are free to buy and sell it at any time.

And there should be a large market of diverse, liquid financial assets in the currency which investors can hold.

The world's pre-eminent reserve currency is the US dollar, which governments, businesses and private citizens hold in far higher quantities (60 per cent of world official reserves) than required for trade and investment transactions with the US (22 per cent of world totals).

This situation is not the result of any international agreement or regulation, but the outcome of market forces. In a sense, the US is exporting the services of its efficient domestic financial markets - even China's government has difficulty finding alternatives to holding US government debt in its foreign reserves.

The IMF has designated the dollar, euro, pound sterling and yen as "reserve currencies" on which IMF Special Drawing Rights or SDRs - a type of little-used international reserve currency - are based.


A country which accumulates official reserve assets in a particular foreign currency has to earn it by exporting more than it imports, or by borrowing in that currency. The country that supplies such reserve assets thus incurs liabilities to others, as the US does, given the strong global demand for "international" assets denominated in the dollar.

Statistically, this is a balance of payments deficit, in exchange for which the country issuing the "reserve currency" can obtain funds more readily and cheaply from foreigners, given their demand to hold its assets.

But it is domestic issues which explain China's quest to have the yuan become a reserve currency. Many in China's leadership understand that to reach the next stage of economic development, the country's financial markets and institutions must be liberalised, doing away with distorted interest rates to achieve more efficient capital allocation.

But there are others in China's government who believe that financial markets are too important to be left to market forces, invariably associated with crises and subsequent political turmoil.

Yuan internationalisation provides a means to accomplish domestic financial market reform by the "backdoor", riding on popular nationalistic sentiment that China deserves an international status commensurate with its role as the world's No. 2 economy, possibly destined to become No. 1.

Measures necessary for the yuan to become a reserve currency include: removing currency restrictions to make it fully convertible, lifting barriers to inward and outward foreign investment, allowing increased financial market competition (including from foreign institutions) to deepen capital markets, privatising state-owned banks, establishing credible monetary policy, and providing legal and governance institutions that ensure transparency, accountability and secure property rights for savers and investors of any nationality.


Functioning as a reserve currency does not come from a formal status bestowed by the IMF, but must be earned through winning the trust and confidence of private market participants as well as foreign governments.

In China's case, the need to reduce state control and depoliticise domestic financial institutions will be a particular challenge. In addition, the yuan suffers from the same time-zone disadvantage as the yen.

Since the Asian business day ends when Europe and Africa have barely started work and the Americas are still asleep, anyone trying to use liquid balances in Asian currencies to manage their international payments is always one day behind.

Also, if IMF member countries agree to include the yuan in their Special Drawings Rights basket of reserve currencies on condition it is made fully convertible, the impact on China's domestic financial market reforms would be substantial. Until such major - and difficult - reforms take hold, the yuan will be limited to the role of a significant regional currency.

•Linda Lim is Professor of Strategy at the Stephen Ross School of Business, University of Michigan. Gunter Dufey is Professor Emeritus at the Ross School, and member of the banking and finance faculty at Nanyang Business School, Nanyang Technological University.

A version of this article appeared in the print edition of The Straits Times on July 04, 2015, with the headline 'Plumbing the depths of currency controversies'. Print Edition | Subscribe