Over the last several years, the issue of China's currency revaluation has been increasingly brought to the forefront. The reason why, is because many of the developed nations (i.e. The United States and the European Union) are experiencing unusually large trade deficits, while China is seeing trade surpluses. This is important, because issues such as currency disputes can have ripple effects on the world economy. Where, the actions taken by one major player can cause various imbalances to occur elsewhere. A good example of this can be seen with recent quantitative easing measures taken by the Federal Reserve. What happened was the as the stimulus has begun to wane over the last several months, many economists have begun to question if the world would experience a second (double dip) recession. This is where the economy will move into a stage of zero growth and will then begin contracting. To avoid this kind of situation, the Fed would begin to aggressively buy U.S. Treasuries. The idea was that this would drive down long-term interest rates, helping to spur inflation and jump start the economy. The problem with this kind of action is that it will force the currencies of many developing countries to rise sharply. This is problematic in the case of China, as these kinds of actions could help destabilize their currency and the economy. Evidence can be seen with comments from Former Fed Chairman Alan Greenspan in the China Daily newspaper. Where he wrote, "Many in China fear that removal of capital controls that restrict the ability of domestic investors to invest abroad and to sell or to purchase foreign currency, which is a necessary step to allow a currency to float freely, could cause an outflow of deposits from Chinese banks, destabilizing the system. Financial instability in a big emerging economy (such as China) would present a risk to the global economic outlook." ("RMB Floating Could Be Risky ") This is significant, because it shows the challenges that are faced when addressing any kind of currency issues. As the policy decisions by one central bank could have ripple effects around the world. To fully understand the different views on this complicated issue requires conducting a detailed analysis of: the reasons why developed countries (such as the U.S.) wants the currency to rise, how the two countries (the U.S. / China) have reacted to these views, what will be financial consequences of these actions and what will other nations do to defend their own interests / currencies. Together, these different elements will provide the greatest insights as to the long-term impact that the currency debate will have on the global financial system.
The Reasons Why the U.S. Wants the Yuan to Rise
From the perspective of United States, if China were to allow the yuan to float freely, it would have a dramatic impact upon the U.S. economy. This is because increases in the yuan, would play an interconnected role in helping to adjust the obvious imbalances (from the government using the dollar peg). The biggest reasons why they are pushing China so hard on this issue includes: it can make American products more competitive in Chinese markets and it can dramatically reduce the trade deficit. ("Paulson Promotes Letting Yuan Rise")
When you look at the first reason (a rising yuan can help make American goods more competitive), it is clear that if the Chinese government allowed the currency to float freely against the dollar it would see an immediate appreciation. This is because the peg that is being utilized by the government is artificially undervaluing the yuan. When you remove this cap, all of the pent up demand will cause significant price increases in the currency. At which point, American corporations will begin to see their different goods and services more competitively priced in these markets. Once this takes place, it means that many Chinese consumers will begin purchasing various American products, because they are more affordable. Over the course of time, these increasing profits will translate into a positive trade surplus with China. As the lower priced American products, are helping to fuel an increase in imports (causing the trade deficit to decline). This is significant, because if the United States can persuade China to allow the currency to float freely against the dollar. The various imbalances in the world economy would naturally adjust. This, (the U.S. argues) would provide the most stability for the global financial system, as the markets should determine the best rates for currencies vs. The central banks. ("Paulson Promotes Letting Yuan Rise")
How the U.S. And China Have Reacted to these Views
The U.S. believes that China is beginning to engage in mercantilism. This is when you will flood your trading partners with cheap exports (in an effort to force them to run a deficit). While the country doing the large amounts of exporting, is able to run a trade surplus at the expense of their trading partners (helping to increase the financial resources of the country running the surplus). This is problematic, because the U.S. has been running consistent trade deficits over the last several years. As a result, the inability or unwillingness of the Chinese government is causing many in the U.S. government, to claim that China is artificially manipulating their currency (to achieve this objective).
As far as China is concerned, they would like to take a more gradual approach when it comes to issues surrounding the yuan. The reason why is because sudden changes in the valuation of the currency, could have a negative impact upon labor prices and the economy as whole. Where, the revaluation would have drastic adverse effects upon the way the economy is currently structured. Meaning, that any kind of sudden shifts could cause Chinese exports to become more expensive in American markets; having negative impacts upon their overall bottom line (resulting in layoffs). Once this takes place, it could cause unemployment levels to rise, as the upward trends in the yuan is siphoning off the benefits of lower labor costs. This is problematic for the Chinese government, because they are trying to improve the standard of living and the economic opportunities for the people. As a result, these two different views are causing heated debate about how the Chinese government should be addressing this issue.
What will be the Financial Consequences of these Actions?
There are a number of different financial consequences that could result from these actions the most notable include: a currency war, maintaining the status quo and China agreeing to the let the yuan float freely against the dollar. A currency war is a very realistic possibility at this point. The reason why, is because the actions taken by the Federal Reserve (the purchasing of U.S. Treasuries) will cause the price of dollar to collapse. This will force foreign investment capital to dry up in China. As the falling dollar will allow inflationary pressures to increase and it will put strain on the banking system. These two elements could indirectly force China to allow the yuan to increase against the greenback, as this action would help to alleviate the pressure that it will be facing. However, if no action is taken and the peg remains in place, this could help to fuel hyper inflation, which would cause China's economy to overheat. This is significant, because one could argue that the actions taken by the Fed may be inadvertently starting a currency war. Where, China may be forced to retaliate or take direct measures to allow the yuan to float freely. As far as retaliation is concerned there are host actions that China could take to include: selling their holdings of U.S. Treasuries, increasing tariffs / trade barriers and making it more difficult for American-based businesses to operate. (Braningan) If this happens, it could throw the world economy into a depression. (Parsons) The challenge going forward, will be determining how the Chinese government will react to these events. As one could easily argue that the U.S. is taking unilateral action, to place pressure on China and help to stabilize its own economy. ("RMB Floating Could Be Risky") (Parsons)
A second possibility is that the status quo could be maintained. This is highly unlikely as the U.S. And China, have been negotiating on this issue for the last several years. The fact that the U.S. is facing, the possibility of another recession and the increasing budget surpluses of the Chinese government are making this situation worse. As a result, the status quo will be changing at some point in the future, due to these two elements. Recent evidence of this can be found with the G20 summit, as the issue of currency and interest rates contributed to the heated atmosphere. (Parsons)
A third possibility is that China could remove the peg from the dollar and allow the yuan to float freely. This is questionable at best, the reason why is because such a move could cause a…