On September 3, 2003, the finance ministers of G7 industrialized countries endorsed "flexibility" in exchange rates, a code word widely regarded as an encouragement for China and Japan to stop managing their currencies. Both countries have been actively intervening in the foreign exchange market to weaken their currencies against the dollar and thereby improve their exports. China and Japan had been seen buying billions of dollars in U. S. Treasury bonds. The G7 statement prompted massive selling of the U. S. dollar and dollar assets. The dollar fell 2% against yen, the biggest one-day drop that year, and U. S. Treasury bonds saw a steep decline in value as well. Required:
a. How did China and Japan manage to weaken their currencies against the dollar?
b. Why did the U. S. dollar and U S. Treasury bonds fall in response to the G7 statement?
c. What is the link between currency intervention and China and Japan buying U. S. Treasury bonds?
d. What risks do China and Japan face from their currency intervention?

a. How did China and Japan manage to weaken their currencies against the dollar?

Both countries managed to weaken their currencies by purchasing a lot of US government securities, therefore, increasing imports of financial assets which caused their trade surplus to balance or even become a deficit. Japan is not currently carrying out this policy anymore, but China is a different story.

China is a mixed economy where private firms are co-owned by the government, and they are highly regulated. Also, only private firms that are friendly with government officials prosper. E.g. back in March, one of China's richest businessman criticized the government and its handling of the current health crisis, and he was thrown into jail and sentenced to 18 years in prison.

This results in the Chinese government having a lot of power to guide how Chinese corporations work. The Chinese government artificially undervalued the yuan by purchasing foreign securities (not only US bonds, but also European bonds). Even though China has a trade surplus, its currency didn't appreciate like a normal currency would. This allows Chinese products to be cheaper and more competitive.  

Even when the Chinese government said that they (as the government) would stop purchasing foreign securities, they ordered Chinese companies to do so. At the end the result was the same, China balances its currency through purchases of foreign securities either directly or indirectly (through companies co-owned by the government).

b. Why did the U.S. dollar and U S. Treasury bonds fall in response to the G7 statement?

Japan decided to stop purchasing US securities like crazy, and since the demand for US securities dropped dramatically, plus some US securities were sold by Japan (increased supply), the equilibrium price shifted. It is simple and basic law of supply and demand. Supply increases while the demand falls, the equilibrium price will decrease.

c. What is the link between currency intervention and China and Japan buying U.S. Treasury bonds?

Currencies appreciate or depreciate based mainly on the balance of payments between countries. If the US starts to buy a lot of goods from Brazil, and Brazilians do not buy US goods, then the price of the Brazilian real will appreciate against the US dollar. This will make Brazilian goods more expensive, making US consumers purchase less Brazilian goods which will eventually balance the value of the currencies back to normal.

The problem with China and Japan (as explained before) is that they have huge trade surpluses with the US. But in order to prevent their currencies from appreciating against the US dollar, the governments purchased US securities. That way their balance of payments balanced and their currencies were not affected.

d. What risks do China and Japan face from their currency intervention?

It makes imported goods artificially expensive. This favors domestic production but eventually hurts consumers. E.g. in China there are a lot of cheap domestic cars that are lets say, not the best cars you can find, and they would not be sold in developed countries like the US. But if you want a decent car, like an Accord, that costs around $30,000 in the US (medium trim), you will have to pay at least twice as much in China.

No country in the world can simply decide to only export goods and not import anything. It just doesn't work. trade goes back and forth. This is the same reason why President Trump's idea of restricting imports to the US didn't work, and never will. You can benefit a certain group of people or industries by restricting imports, but eventually the rest of the economy suffers.

Japan is an absurdly expensive country because it needs to import a lot of goods, but it artificially makes imports more expensive. The same thing happens to China. Chinese products are cheap, but China needs a lot imports also, e.g. food. China is not able to produce enough food to feed its people, and it imports most of the food that is consumed there. By selling expensive food, you are hurting the middle and lower classes. Of course this will not affect a millionaire, but 95% of Chinese are either poor or middle class.

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