The US continues to argue that China is keeping its currency artificially undervalued, thus unfairly helping Chinese exporters. But what might a yuan revaluation mean for the world's markets?
China has held the yuan in a de-facto peg to the dollar since the worsening of the global financial crisis in mid-2008, meaning its currency has weakened against those of other trade partners as the value of the dollar has slid over the past year.
Yet long-standing tensions over China's trade surplus and monetary policy remain entrenched. China has repeatedly said that its currency policy has been an important source of stability during a period of international financial turmoil, benefiting both the Chinese and global economic recovery. During the most intense phase of the financial crisis, from September 2008 to March 2009, the dollar peg actually meant that the yuan appreciated strongly against virtually all other currencies in the world.
China began a programme of increased yuan flexibility in July 2005 and steadily strengthened its value, from about 8.2 yuan to the dollar to around 6.8 by July 2008. But the yuan has been held at roughly that level ever since that time. If China discards the existing currency peg and allows market forces to dictate the yuan’s value, then the value of China’s holdings of US debt would decrease relative to the appreciation of the currently undervalued yuan. However, in the short term an appreciation of the yuan would also make it cheaper for China to buy US dollar-denominated commodities.
In the longer term, the value of the yuan may find an equilibrium at a lower level since an appreciation would eventually weigh on Chinese exports and GDP growth. But in the interim stages, China may decide to leverage any strength in the value of a free-floating currency to buy commodities while they are relatively cheap. This hypothetical situation would continue to fuel a commodity rally.
The biggest market risk factor for 2010 comes from the point at which this trend colours US-China relations.
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Updated: 12/02/10