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 (which is also called the renminbi) in a de-facto peg to the US dollar since the global financial crisis worsened in mid-2008. In doing so, its currency has weakened against those of other trade partners, including Australia, as the value of the US 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), China's fixed exchange rate to the US dollar actually meant that the yuan appreciated strongly against virtually all other currencies in the world.
In July 2005, China began a program of increased yuan flexibility (to use mutliple currencies as reference points) and steadily strengthened its value, from about 8.2 yuan to the US dollar to around 6.8 by July 2008. But the yuan has been held at roughly that level ever since. If China discards the existing currency peg and allows market forces to dictate the yuan, then the value of its US debt holdings would decrease relative to the appreciation of the currently undervalued yuan.
In the short term however, an appreciation of the yuan would also make it cheaper for China to buy US dollar-denominated commodities. In the longer term, it 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: 22/02/10