Currency manipulation is one of the key areas of contention over the Trans Pacific Partnership, and many believe that currency management is the most important issue in international economic affairs. Some argue that the large U.S. trade deficits over the past 15 years are primarily due to such currency management by U.S. trading partners.

While not included in the TPP, China is often criticized as the exemplary offender, intervening in foreign exchange markets to artificially hold down the value of its currency, making its exports relatively more competitive. As undervaluation of the Yuan appears self-evident to many U.S. policy makers, the question becomes by how much is it undervalued? Yet, currency manipulation is not as self-evident as some would like to believe, and with China’s foreign exchange reserves at their lowest point since 2013 it is not obvious that the Yuan is undervalued.

A Brief History of the Dollar to Yuan Exchange Rate

While pegging the value of the Yuan to the U.S. dollar in 1994 at a rate of 8.7, China has generally allowed its currency to appreciate relative to the dollar over the last 20 years. China allowed the Yuan’s exchange rate with the dollar to rise to 8.28 by 1997, and it then held there until July 2005.

The peg was reformed on July 21, 2005, allowing the Yuan’s rate to rise to 8.11 with the dollar and fluctuate by a small percentage against a basket of other currencies. Until 2008, the Yuan appreciated under a ‘managed float’ that allowed the market to determine the direction of the currency’s movement while the government restricted the rate at which appreciation occurred. By July 21, 2008 the Yuan’s exchange rate with the dollar was 6.83.

Due to the global financial crisis in 2008 and the subsequent lack of global demand for Chinese exports, China halted the appreciation of its currency, keeping the rate of dollars to Yuan at 6.83. Appreciation then resumed on June 19, 2010, and the Yuan climbed to 6.17 by July 10, 2013.

The fact that market forces have been pushing the value of the Yuan upward over the past 20 years suggests that China has been intervening to keep its currency low relative to the dollar in order to boost demand for its exports. However, the more recent trend has caused a drop in China’s foreign exchange reserves, as it has been selling its dollar holdings to stabilize the Yuan, effectively keeping it from depreciating rather than appreciating.

Is the Yuan Really Undervalued?

It is no wonder then that the International Monetary Fund (IMF), which has acted as the world’s go-to exchange-rate policy assessor, believes the Yuan is approaching its market equilibrium value contra U.S. Treasury officials. Data from 2013, the latest from the IMF, indicates that the Yuan is anywhere from 5-10% undervalued. Harvard Kennedy School Professor Jeffrey Hankel argues that recent purchasing power parity (PPP) statistics would indicate that the Yuan is in a relatively normal range.

Furthermore, while U.S. policymakers point to the United States’s significant trade deficit with China as evidence of an undervalued currency, their focus indicates a bias towards U.S.-China bilateral trade. The value of a currency, however, should reflect its relationship with the currencies of all trade partners. Considering Chinese multilateral trade reveals that China actually runs trade deficits with Saudi Arabia, other oil and mineral exporters, and South Korea.

It is also important to consider inflation rates between two countries, as a higher inflation rate in China relative to its trading partners effectively acts as an appreciation of the Yuan. Over the period from 2005 to 2013 inflation was higher in China compared to the U.S. by 31%, meaning the Yuan’s real exchange rate with the dollar appreciated by 42% as opposed to a 24% increase of the nominal exchange rate.

Factoring in inflation when looking at multilateral trade relationships, it is illuminating to find that while halting the Yuan’s appreciation relative to the U.S. dollar during the period from 2008 to 2010, the real effective exchange rate (REER) appreciated 8.2% relative to a basket of currencies from 61 countries. From June 2010 to May 2013 it appreciated a further 16.9%.

The Bottom Line

While it appears that the Yuan definitely started out as undervalued 20 years ago, it is harder to make a similar case today. Many U.S. policy makers focusing on bilateral trade with China want to argue that the Yuan is still substantially overvalued, while others who consider multilateral trade relationships, like the IMF, believe that the exchange rate is very close to fair market value. Obviously, exact quantitative precision on such matters is nigh impossible, but it is interesting that there are some who believe that if China were to concede to U.S. demands in letting its currency float, it is possible that the Yuan depreciates rather than appreciates.

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