Chinese monetary policy has recently emerged in the headlines, as America and several other major economies have been pushing for the reevaluation of the yuan. Currently, the yuan is pegged to the greenback at approximately 6.83 yuan per U.S. dollar. Only mild currency fluctuations are observed within the tight trading range of the fixed exchange rate, which has been essentially unchanged in the past two years. (Tap into a world of possibilities by going beyond the simple pro- or anti-dollar trade. Find out how in Make The Currency Cross Your Boss.) IN PICTURES: 10 Biggest Losers In Finance
So What's Going On?
Despite the international pressure, the Chinese government has repeated that any changes to its currency will be directed solely by internal economic guidelines, foreign pressures are building up. The United States, along with other nations, feel that the yuan is artificially held at depressed levels in order to guarantee the competitiveness of Chinese exports.
Economic theory suggests that as long as the yuan remains undervalued, foreign companies will continue purchasing cheap Chinese goods; if the currency is allowed to appreciate, the same goods become relatively more expensive in comparison to similar products produced elsewhere. This basic premise is the foundation of the ongoing debate. (Congress often debates pressuring China to appreciate its currency, but the yuan/dollar peg has benefits for both countries. Read more, in Why China's Currency Tangos With The USD.)
What Will the Effect Be?
In 2005, China allowed a 2% revaluation of the yuan, but since July of 2008, the peg has been carefully maintained. Now, there is the possibility that China will allow the yuan to appreciate another 2-5% against the U.S. dollar, an announcement that might have a significant impact on world trade.
While the general relationship between foreign exchange rates and global trade is fairly intuitive, if the yuan appreciates, Chinese goods will not be as cheap, thus other nations can increase their international trade output - actual results are not always dictated by theory. The impact that a Chinese foreign exchange policy modification will have on America can only be determined after the change has been made.
Various arguments have been made that appreciation of the yuan will result in either U.S. job loss, job gain or will have no immediate impacts at all.
As the Chinese economy has regularly seen double-digit annual growth, appreciating by nearly 12% in the previous quarter, the suggested yuan reforms may slow down the soaring economy. China will no longer be able to flood world markets with cheap products that drive out international competition. An increase in Chinese consumer good prices may open the gate to competitors.
Although potential inflation may result, many argue that an increase in the price levels of Chinese supplies will allow United States manufacturing to gain global market share. American firms will not only be able to gain a competitive edge in domestic markets, but will be able to compete in foreign countries, including China as well. Naturally, such an occurrence would lead to elevated levels of employment in the manufacturing sector.
International demand would not only increase for relatively cheaper American goods, but for those of other Asian countries as well, who have been unable to compete with Chinese exports. (Everything you need to know - from the different types of tariffs to their effects on the local economy - can be found in The Basics Of Tariffs And Trade Barriers.)
But What If …
The above scenario logically adheres to economic trade theory; yet, there are many valid arguments suggesting that the positive impacts implied by the revaluation are overly optimistic. Geoff Lewis, head of investment services at JPMorgan Asset Management contends that the currency reforms will be "economically meaningless…. It's more to be seen as doing something, not for its real impact."
Movement away from the current peg might be a symbolic gesture to appease the United States without having any material merit. Chinese firms can comfortably continue supplying goods at reduced margins, in order to maintain their market shares and influence in overseas markets. Rather than reducing their exports, China can directly absorb the financial losses by maintaining the same selling price of its products.
Furthermore, the prices that consumers pay for their Chinese-made toys, for example, do not only reflect production costs, but incorporate domestic transportation costs and store margins. These latter components compose the main bulk of the underlying price tag. If sellers do not cut their prices in perfect tandem with the gradual appreciation of the yuan, then department stores will be the main benefactors, rather than consumers.
The Bottom Line
The full impact of the Chinese currency revaluation can only be speculated, but not actually known until the policy comes into effect. While American policy makers argue that appreciation of the yuan will lead to an increase in employment, some have argued the opposite, saying that it will actually decrease: if the price of inputs goes up, so will the cost of manufacturing, driving some firms out of business.
Still feeling uninformed? Read this week's financial news highlights in Water Cooler Finance: Buffett's Armed and Greece Keeps Falling.