There has been tremendous pressure on China for some time, especially from the US to revalue the Yuan. prompted primarily by the ballooning trade deficit of the US against China.
China and its exchange rate policy
China is primarily an export-oriented country. China fixed the value of the renminbi to the value of the U.S. dollar at a ratio of 8.27 to 1 since 1994. Upon entering the 21st century the U.S. Senate began to debate a bill that would raise U.S. tariffs on Chinese goods by 27.5 percent unless China appreciated its currency to market levels by March 31, 2006.
After significant pressure from the United States, China announced on July 21, 2005 that it moved from a fixed exchange rate regime to a managed float against a basket of currencies. The Yuan appreciated 21 percent against the dollar during 2005-08 before the policy was suspended in July 2008 to protect its exports from subprime crisis volatility. It resumed in June 2010. Indeed, China’s currency has appreciated by about 2.2 percent with respect to the dollar since then.
The following throws light on the consequences if China allowed the Yuan to significantly revalue:
US's notional benefit:
According to a study, if the renminbi appreciated by 25 percent it would initially decrease U.S. imports from China and lead to greater domestic production in the United States and increased exports to China. However, the U.S. economic benefits would be offset by falling exports to China as lower Chinese economic growth would diminish its demand for imports.
The higher price of Chinese imports into the United States would affect the profitability of mass-market retailers, such as Wal-Mart Stores and Target Stores which rely on volume sales of lower-margin goods. If the renminbi continued to appreciate over the long term, major overseas producers such as Nike would shift more of their production to other developing countries, such as Vietnam.
Yuan appreciation would also increase U.S. costs for imported products from China and cause higher U.S. short-term interest rates. The total result was estimated to impart a negative effect on U.S. aggregate demand and output, and result in a loss of 57,100 U.S. jobs.
There is no guarantee that appreciation of the yuan would definitely eliminate the U.S. trade deficit as evidenced by the 21 percent appreciation of the Yuan from 2005 to 2008 which did not lead to any reduction in the trade deficit over that period.
China may be forced to trim its foreign exchange reserves in order to support its currency, which will trigger a sell-off of dollars and potentially the need for the Federal Reserve to raise interest rates in order to support the U.S. dollar. Companies like Countrywide, FannieMae, Bank of America, and Wells Fargo would be impacted if the Fed raised interest rates as the rate hike would have a dramatic effect on residential real estate prices, mortgage lenders and also impact housing companies.
The purchasing power of China automatically rises with an appreciating Yuan -- so it can import foreign goods and commodities at lower prices and increase domestic consumption. China has a huge demand for commodities; it imports billions of yuan of iron ore every year.
A stronger Yuan will reduce its dependence on exports due to boost in domestic consumption.
Chinese corporations such as China Eastern Airlines would see their profits rise by nearly $40 million yearly for every 1 percent annual yuan rise because of devaluation of its US dollar debt.
A stronger Yuan means neighboring countries would be willing to trade in Yuan and hoard Yuan, which would gain prominence in global trade transactions.
On the other side, Chinese exports would be affected especially in textiles, electric and electronic components and a very large one-time revaluation would disrupt China’s growth, which would hurt everyone.
China's marginally profitable manufacturers in the export industries would suffer due to the rising renminbi, triggering off a significant loss of jobs and possible domestic unrest in China.
The gainers from renminbi revaluation include China and its trading partners if it comes with measures that accelerate China’s domestic demand relative to its GDP. The U.S. is in a less favourable position as its imports from China are about three to four times larger than its exports to China. So the U.S. is likely to be a significant net loser from renminbi revaluation and its bilateral trade deficit with China would widen unless offset by a substantial acceleration in China’s growth.
However, some economists have suggested that a strengthening of the renminbi would not make a significant impact in the U.S. trade deficit with China because the U.S. trade surplus with China is associated with a fall in the U.S. trade deficit with other developing economies. As a consequence, even if the U.S-China deficit could be impacted by an increase in the value of the renminbi, offshore production may just shift to another developing country and the U.S. would continue to run the same overall worldwide trade deficit.