China’s practice of pegging its currency, the yuan (also known as the renminbi), to the U.S. dollar has created much speculation in corporate board rooms and controversy among policymakers. Unpegging the yuan from the dollar, a solution advocated by many, may not be so easy. And, it may not achieve what it is intended to do. What’s worse, it could have some unintended consequences.

Will It Rise or Fall?

Congressional sources have declared the yuan to be considerably undervalued, which in turn, make Chinese exports more attractive worldwide. In response, some U.S. politicians and various organizations suggest that China should allow the yuan to float freely, assuming it will rise to a higher level.

On the other hand, some economists believe that if this were to occur, the currency may become volatile due to China’s weak financial sector, instability associated with the country’s transition to a market economy and difficult economic adjustments associated with WTO-mandated reforms. In turn, a widely fluctuating yuan could have a destabilizing effect and fall well below current levels. In this less likely scenario, a falling yuan could lead to a financial crisis.

The Outcome Is Unclear

Regardless of these arguments, a revaluation of the yuan is likely to have little impact on the U.S. trade deficit. Why? If the yuan were to rise in value, U.S. companies would continue to seek low cost imports from other developing countries.

In his June 23, 2005 testimony before the U.S. Senate Committee on Finance, Federal Reserve Chairman Alan Greenspan said, “An increase in the exchange rate of the renminbi, relative to the dollar, would likely redirect trade within Asia, reversing to some extent the patterns that have emerged during the past half century. However, a revaluation of the renminbi would have limited consequences for overall U.S. imports, as well as for U.S. exports that compete with Chinese products for third markets.”

If China were to revalue its currency, other Asian countries would become more comfortable in allowing their currencies to appreciate against the dollar, according to the Deloitte Research report, China at a Crossroads: Seven Risks of Doing Business. The result: the U.S. would ultimately experience an improvement in its current account balance. How much? Economists suggest it would be minimal.

The Other Impact on China

Although the full impact of a floating yuan is uncertain, many analysts agree it is increasingly likely that China will allow the yuan to appreciate against the dollar. They also agree that continued pegging of the yuan to the dollar negatively impacts China.

In a May 2005 report to Congress, the U.S. Treasury Department said the yuan’s peg “blocks the transmission of critical price signals, impedes needed adjustment of international imbalances, attracts speculative capital flows and is a large and increasing risk to the Chinese economy.”

It also is widely agreed that the pegging policy hurts low-cost global producers who compete with China for global market share.

Market Forces Should Dictate

The yuan-dollar pegging policy originally began when the dollar was strong and China was considered an economy in need of development aid. Now that China has become a strong international player, especially in the manufacturing sector, and one that is seeking higher technologies, many argue that China is ready to implement a more flexible exchange rate.

To play fair on the world stage, China should take steps to achieve currency convertibility based on market forces. When, not if, may be the more appropriate question.

This article appeared in Impact Analysis, July-August 2005.

John Manzella
About The Author John Manzella [Full Bio]
John Manzella, founder of the Manzella Report, is a world-recognized speaker, author of several books, and an international columnist on global business, trade policy, labor, and the latest economic trends. His valuable insight, analysis and strategic direction have been vital to many of the world's largest corporations, associations and universities preparing for the business, economic and political challenges ahead.

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