China depresses the price of its exports by manipulating its currency.
By keeping China's currency artificially low, it makes it seem like all their exports are lower than they really are. China's manipulation of its currency is like a massive subsidy the
Chinese government gives all of its companies.
Currency manipulation occurs when countries sell their own currencies in the foreign exchange markets, usually against dollars, to keep their exchange rates weak and the dollar strong. These countries thereby subsidize their exports and raise the price of their imports, sometimes by as much as 30-40%. They strengthen their international competitive positions, increase their trade surpluses and generate domestic production and employment at the expense of the United States and others.
About 20 countries, most notably China, have engaged in such practices over the past decade at an annual rate that has averaged $1 trillion in recent years. The U.S. trade deficit has been several hundred billion dollars a year higher as a result and we lost several million additional jobs during the Great Recession. Currency manipulation is, by far, the world's most protectionist international economic policy in the 21st century, but neither the U.S. government nor the responsible international institutions, the International Monetary Fund and the World Trade Organization, have mounted effective responses.
How does China manipulate its currency? By buying U.S. government debt. In a free market, a trade surplus should increase the value of a country's currency. People want to be paid in local money, creating demand for the currency, which in turn raises its value. Over time, this provides a counterweight against runaway trade imbalances. That process doesn't happen in China, because the government constantly prints new currency and uses it to buy U.S. dollars and U.S. government debt, thereby flooding the market with Chinese currency and increasing demand for American dollars. As of this writing, China holds $1.15 trillion in U.S. government debt, and the country's foreign exchange reserves are nearly as great as those of all advanced economies combined.
Until June 2010, the Chinese government dictated the value of the yuan against the U.S. dollar, a strategy known as "pegging." China claim to have abandoned the pegging system, but the country still manages the value of the yuan within a narrow range. According to many estimates, Chinese government intervention keeps the yuan approximately 20 percent below its free market value against the dollar.
Is currency manipulation legal?
No. International law grants sovereigns the right to manage their currencies, but a country can limit those rights through international agreements. China's membership in the IMF requires the government to "avoid manipulating exchange rates ...
in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members."
The IMF agreement, however, is toothless. China claims that it manages its currency to ensure domestic stability, not to cheat trading partners, and there's no venue in which anyone can effectively challenge that claim.