In June 2010, China’s central bank announced that it would allow its currency, the renminbi (or yuan), to fluctuate more freely against foreign currencies. The move was welcomed by the international community, which had accused China of keeping its currency artificially low for at least the past decade.¹ 

The announcement was also particularly timely, released a week before the G-20 meeting of finance ministers from the world’s richest countries, in Toronto. Until the announcement, many had assumed that China’s controversial currency policy would be the meeting’s central focus.²

Background- Understanding the Controversy

China’s decision to allow its currency to float promises a fundamental change in its monetary policy throughout the majority of the past decade. Since the beginning of the century, economists and scholars have accused China of keeping the renminbi artificially undervalued, relative to the US Dollar. Critics have become more vocal in the past few years—in March 2010, Senator Charles Schumer (D-NY) introduced a bill that could declare China’s currency a form of trade manipulation.³ 

What does it mean when a currency is undervalued? In general, market forces, such as supply and demand determine how much currencies are worth. These forces are different every day, and exchange rates are constantly changing. But such is not the case in China.

Instead, the Chinese government determines the value of its currency by law. Every morning, China’s central sets the rate at which the renminbi is traded. Since 2008, the renminbi has been pegged at about 6.83 renminbi per dollar.⁴  Since the Chinese government has total control over the flow of money in and out of the country, whatever rate the central bank sets is final.

According to many economists, if markets determined the renminbi’s exchange rate, it would be much higher relative to the dollar. The Economist’s Big Mac Index (see the ‘Exchange Rate’ section of our Trade Issue Brief) indicates that the renminbi is 40 percent cheaper than it should be.

One indication that the currency is indeed undervalued can be seen in the years 2005-2008, when China’s central bank did let the exchange rate fluctuate according to market forces. In that period, the renminbi appreciated by 20 percent.⁵

Global Consequences of an Undervalued Renminbi
 
An undervalued currency has direct consequences for all of China’s trading partners. It makes Chinese goods cheaper for foreigners to buy and, conversely, makes imported goods more expensive for Chinese consumers. This pushes the Chinese economy towards more exports, fewer imports.

As a result, China has been running an increasing trade surplus with the U.S. and Europe.⁶  Many consider this an unfair trade advantage, because it allows Chinese exporters to sell their goods for less than exporters in other countries. Senator Max Baucas (D-MT) put it succinctly: “China’s currency practice has cost American jobs and hurt American ranchers, farmers and small businesses.”⁷

New York Times columnist Paul Krugman emphasizes the importance of this trade imbalance during a global economic slump. What the world needs is increased demand to create jobs, and the undervalued currency discourages Chinese consumers from buying foreign goods. This only aggravates the problem.⁸

But pressure to revalue the renminbi has not come only from the United States. Developing countries also have a vested interest in a flexible renminbi. Henrique Merelles, head of Brazil’s central bank, says that an appreciated Chinese currency is “absolutely critical for the equilibrium of the world economy.”⁹ 

In India, Duvvuri Subbarao, governor of India’s central bank, notes that “If some countries manage their exchange rate and keep them artificially low, the burden of adjustment falls on some countries that do not manage their exchange rate so actively.”¹⁰

The Announcement- A New Direction?

China’s announcement was met with mixed reactions. Both the Obama administration and a number of large U.S. corporations praised the move. Obama’s official statement read: “China’s decision to increase the flexibility of its exchange rate is a constructive step that can help safeguard the recovery and contribute to a more balanced global economy.”¹¹

One caveat to China’s decision, though, was that it did not appear that the currency would appreciate by anything more than minor increments. This is due partly to the wording of the announcement, which stated that the renminbi would be flexible relative to a ‘basket of currencies,’ i.e. multiple currencies, including the Euro.

The Euro has been falling in value for some time now, which has allowed member countries of the EU to reap the benefits of a strong renminbi (relative to the Euro) for the past few years.  The EU has more to gain from an appreciated renminbi, and rising Chinese wages: their exports tend to go to the (newly empowered) Chinese consumers, while U.S. exports to China are more narrowly focused on industrial products, like airplanes and wind turbines.¹²

But the effects of the move are global, impacting all countries that deal or compete with China. Nearby Asian countries, such as South Korea, Malaysia and Taiwan, in an attempt to keep their exports as competitive as China’s, have also been keeping their currencies artificially low. The flexible renminbi will presumably lead to similar changes in those countries’ currencies.¹³ 

Krugman was especially skeptical about the announcement, asserting that it was a purely political move, with few significant consequences for the exchange rate: “Having the currency bob up or down slightly makes no difference to the fundamentals.”¹⁴ 

Others don’t even see that much good in an appreciated renminbi. The Economist points out that because of China’s tendency to re-export (importing items that they augment and then export), a decrease in China’s exports doesn’t necessarily mean increased imports. The global demand so dearly needed by the world economy might not come from a more expensive renminbi.¹⁵ 
 
In an Op-Ed for the International Herald Tribune, Bezhad Yaghamaian, a professor of Political Economy at Ramapo College, sees the flexible renminbi as part of a much bigger story: China’s new stage of globalization. He notes that the announcement accompanies another surprising development within China. Labor strikes in factories around the country (most notably, Toyota and Honda plants), have not been suppressed as strongly as one might have come to expect from the Chinese government.

In 2007, a law was passed requiring employers to sign formal contracts with their workers. It seems that China is taking a new, more supportive stance on labor. Yaghamaian sees China as leaving its first stage of globalization, where it relied on low-end exports whose competitiveness came mainly from cheap labor. Instead, the government is investing heavily in high-tech research and production. Such a shift would mean a lot to developing countries, who might now be allowed a foot into the globalization door.¹⁶ 

The world will watch closely over the next few months to see if China’s announcement was a signal towards a new direction in the global economy, or merely political talk.