People's Republic of China situated in eastern Asia, bounded by the Pacific in the east, the third largest country in the world having an area of 9.6 million square kilometers, or one-fifteenth of the world's land mass has emerged as one of the major economic powers on the global scenario and stands among one of the fastest growing economies in the world in the recent years. According to the latest statistics from China's General Administration of Customs, China's foreign trade continued its robust growth in the first half of this year as its trade volume rose about 23.2 per cent year on year in the first six months this year to 645 billion USD. Exports from China grew to some 342.3 billion USD in the first half of this year, a 32.7 per cent rise over the previous year; imports to China reached 302.7 billion USD in this period, a year-on-year rise of 14 per cent. China's foreign exchange reserves skyrocketed to US$711 billion as of end June on the back of its trade surpluses. China still exercises foreign exchange controls, which means that enterprises cannot keep all of their foreign currency earnings and that a large part of foreign exchange inflows become the country's reserves.

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Recently, there have been consistent talks about Chinese Yuan value and there was continuous pressure on the country to allow its currency to freely float in the market rather than just pegging it to the US dollar at 8.28 per dollar a step taken in 1998. For several months, politicians in the United States and Europe have been browbeating China to allow its currency to float freely in global markets. G7 finance chiefs kept on repeating a joint call for "more flexibility" in exchange rates, widely viewed as a veiled reference to China's pegged Yuan. The G7 rich nations' frustration over China's fixed currency regime seemed to be growing as strong language was also used for urging China to revalue its currency. Alan Greenspan, the FED Chairman remained of the view that a revaluation of the Chinese Yuan is unlikely to lower the U.S. trade gap since U.S. consumer demand will shift to products made by China's competitors rather than domestic U.S. products. On the other end, it seemed that China was unlikely to bow to foreign pressure and was setting the stage for a shift in currency policy at its own pace. Chinese vice Finance Minister Li Yong once said that he did not think upward pressure on the Yuan was so great and said he believed the pressure for the currency to appreciate stemmed from domestic, not external, factors. Li, speaking at the Asian Development Bank meeting in Istanbul, also urged currency speculators to be patient over Yuan reform.

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However amid rising pressure from trading partners, China's central bank announced on 21st July that it will stop pegging its currency to the dollar — a change that could have potentially far-reaching effects on the global economy and U.S. consumers, depending on how far Beijing ultimately goes. The Yuan gained 2.1 percent after China surrendered to pressure from the U.S., Europe and Japan to abandon its currency peg versus the dollar. China announced that its currency, the RMB Yuan, will be traded at a rate of 8.11 to the US dollar starting 19:00 Thursday, and the Yuan to US dollar pegging system is switched to a basket of foreign currencies. The central bank said starting from July 21, it will publish the trading rates between the RMB and major foreign currencies at the closing of daily market trading, and the announced rates will be used as the central parity for the following trading day. The announcement further said that the trading price between the dollar and the Yuan at the inter-bank foreign exchange market will float within a 0.3 percent band around the official central parity, while the trading prices between the Yuan and non-US dollar currencies will float within a certain range around the official central parity. The central bank will readjust the floating band at appropriate times according to market development conditions as well as economic and financial situations. The official announcement said: "The RMB exchange rate will be more flexible based on market condition with reference to a basket of currencies. The central bank is responsible for maintaining the RMB exchange rate basically stable at an adaptive and equilibrium level, so as to promote the basic equilibrium of the balance of payments and safeguard macroeconomic and financial stability."

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Albeit smaller than expected, Thursday's decision by China to revalue its currency against the dollar by 2% and to peg its currency against a basket of currencies was surprising. Most of the currency strategists and economists were expecting China to revalue later in the year by as much as 3-5%, but this move was a smaller 2%. The interesting thing is that China moved immediately to pegging its currency to a basket of currencies rather than revaluing solely against the dollar before pegging to a basket. This basket smoothes out FX fluctuations as it spreads the impact of the Yuan’s rise against a group of currencies such as the dollar, euro, yen, Korean Won and Aussie.

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As it was expected, most of the Asian currencies immediately surged after Yuan revaluation. Asian currencies surged, led by the Korean won and Taiwan dollar, after China allowed the Yuan to rise against the dollar for the first time in a decade. The won surged 1.4 percent to close at 1,021.30 against the dollar as of 3 p.m. in Seoul, its largest advance since Feb. 22, according to Seoul Money Brokerage Services Ltd. Taiwan's dollar rose 1 percent to NT$31.648, its biggest gain since May 29, 2001.

The yen which was often traded as a proxy currency for the Yuan also went up and tested support at 110.80, with additional support at 110 and 109.70. The Japanese currency, firming on the expectation that China's Asian trading rivals would allow their own currencies to strengthen, on Thursday made its biggest one-day rise against the dollar in more than three years.

Sterling temporarily broke above $1.76 on news of the Yuan revaluation and settled to around 1.7560-70. The euro was also boosted against the dollar following news that China was going to begin pegging its currency to a basket of trade-weighted currencies, thus increasing the need for China to hold more reserves in euros and less in dollars.

However on Friday, the dollar regained some of its previous session's steep losses against the yen as markets pondered the implications of China's move to drop the Yuan’s peg against the dollar. Investors took a step back to consider the impact on currencies and the global economy, with many details unclear about China's revaluation. In late afternoon trade, the dollar had risen 0.9 percent to 111.30 yen <JPY=> after falling on Thursday by 2.5 yen to a three-week low of 109.85 following China's news.

Asian currencies were uniformly tipped to appreciate in the long-term following China’s announcement on Thursday that it had abandoned the Yuan peg for a managed float against an undisclosed trade-weighted basket of currencies.

The region’s economic growth rates were also expected to get a boost, according to analysts who further predicted China’s move would inevitably be the start of a long process of the Yuan regime becoming more flexible.

The most immediate impact came in Malaysia, which announced virtually straight after China Thursday that it had scrapped the ringgit’s seven-year-old peg to the dollar in favor of a managed float.

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After the move, Federal Reserve Chairman Alan Greenspan told the Senate Banking Committee "This is certainly a good first step. They've (China) been cautious, and I think admirably so. But I look at it as the first step in a number of further adjustments as they invariably increase their participation in the world  trading markets."

"They've put in place a mechanism that provides room for significant movement over time in the currency, and they've expressed a commitment to using market forces to let the currency move," Treasury Secretary John Snow said Thursday. "I think today's developments are extremely positive."

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Two days after Yuan’s revaluation, Head of China's Central bank Zhou Xiaochuan described the revaluation move to be an initial step whose benefits outweighed its drawbacks and said that the central bank would adopt a gradual approach to reform of the country's exchange rate regime.

"We made an initial 2 percent adjustment of the exchange rate level. China's overall buying power has been increased; the currency is stronger and has more value. The positive effects on the economy will be much, much greater than the negative effects," Zhou said.

“The revaluation would help smooth out global trade imbalances but will not have a big impact on America's trade deficit. After the change in the exchange rate, export companies should probably increase their prices. That can help correct imbalances in global trade in an orderly way," he added.

While giving a straight forward answer to a question that whether China’s recent move is taken due to the international political pressures, Zhou said that China had made the shift not because of foreign pressure but because it would promote China's long-term growth and stability. “China had dropped the dollar peg because the U.S. currency had become too volatile in recent years, partly reflecting economic problems include large trade and budget deficits. The renminbi revaluation will help the U.S. trade deficit but the effect will be extremely small because the U.S. economy is so huge. China's economy was just on-seventh the size of America's," Zhou said. Actually Beijing had decided against a larger move of 5 percent partly out of concern that cheaper imports would squeeze domestic firms and trigger deflation. A 5 percent revaluation would shave 1.4 percentage points off of China's economic growth and bring consumer inflation down 1.4 percentage points.

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Initially it was thought that China’s move will be an all-round negative reaction for the dollar. More importantly, it was expected that market could see further dollar declines and increased speculative pressure on the Yuan as it expects further revaluation since this was a relatively small step. However The People's Bank of China has said that last week's 2.1 percent revaluation of the Yuan did not mean further adjustments to the currency would follow.

It was also expected that China could allow the Yuan to rise by this maximum 0.3% every day until we could see a 6% in a month and 30% after 5 months. Nonetheless, the PBC and the Chinese government according to one school of thought said will closely watch the developments in its currency. According to them, the revaluation impact on currencies should be:

• Benefiting the Japanese yen on the idea that Japan's exports will be propped especially as they make up 15% of total Chinese imports.

• Benefiting Asian currencies including the Japanese currency since these nations will be more acceptant in allowing the currency to strengthen as their large trading partner (China) has initiated the move.

• Benefiting the commodity-dependent currencies of Australia, Canada and Norway since these will gain from China's improved purchasing power for energy, metals and agricultural products.

The revaluation will increase China's purchasing power to import commodities, and continue providing valuable support for commodities including gold, hence placing downward pressure on the US dollar. This could help non-Chinese companies with operations in China such as GM, Volkswagen all of which will enjoy the effects of currency translation when converting their operations to their home currencies. The timing was a little surprising. But this is a good sign as far as US-China relations are concerned.

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Big ups and downs of the exchange rate are not in line with the fundamental interests of China since such fluctuations could threaten the country's economic and financial stability. The overall aim of this current exchange rate reform is to build a managed, floating exchange rate mechanism based on market supply and demand and to maintain the Yuan’s stability at a reasonable equilibrium. This is so because of the following reasons:

• The RMB is no longer pegged to a single currency, but to a basket of currencies. The mutual changes of major currencies in the world market will keep fluctuations down.

• The international balance of payment will normalize itself with economic tools including the exchange rate playing a role in resource allocation, and streamlining foreign exchange supply and demand which are considered as solid foundations for a stable Yuan.

• China's macro-economic policies will aim to provide a sound environment for the stability of its currency.

• The PBC itself will endeavor to enhance its fine-tuning ability, improve foreign exchange management and keep the Yuan trading at a reasonable equilibrium.

The PBC said that the exchange rate reform is designed to cater to the need of alleviating foreign trade imbalances, stimulating domestic demand, sharpening domestic enterprises' competitive edge globally and speeding up the country's reform and opening-up.

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The dollar rose against the yen and the euro on Tuesday after China's central bank played down talk of a further Yuan revaluation and attention shifted to upcoming U.S. data for clues about the interest rate outlook. The People's Bank of China has said that last week's 2.1 percent revaluation of the Yuan did not mean further adjustments to the currency would follow. Traders said that while Beijing could let the Yuan rise more against the dollar in the longer term, for now market participants had started to accept that China would not let its currency fluctuate as much as expected. China's revaluation could turn out to be nothing more than a cosmetic attempt to defuse political pressure as there are voices being heard that any further appreciation is likely to be so minimal as to be meaningless.

After Thursday's revaluation of just 2.1 percent, Chinese goods will be only 2% more expensive in the United States, and retailers like Wal-Mart might just bite the bullet and absorb the higher costs. If that turns out to be the extent of the revaluation, it clearly would be a case of too little, too late. However, if Thursday's upward revaluation is the start of an ongoing process of subjecting the Yuan to market forces, the impact could be enormous.

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The revaluation of the Yuan while potentially beneficial to the US in the short-term, could offer a more somber economic outlook in the long-term.

• Domestic manufacturers in the US will find temporary relief from the stifling competition of cheap Chinese imports. US manufacturers have witnessed an influx of Chinese imports, most notably in textile imports, which have flooded world markets after global quotas were lifted in January of this year – the US alone experienced a 9.8% increase in February. A drop in demand for Chinese goods will naturally follow an appreciation of the Yuan as goods become more expensive. But a 2.2% appreciation of the currency will hardly make a dent in US demand for Chinese goods because the cost of Chinese labor remains a mere 3-5% of its US counterpart.
• Yet even if the revaluation were more significant, the break from stark Chinese competition would be short-lived as importers of cheap goods substitute away from Chinese goods in favor of even cheaper alternatives offered by countries in the South-East Asia and in South and Central America. Reports show that US retailers, including retail giants Wal-Mart Stores Inc. and Gap Inc., among others; had already increased their purchases of inexpensive clothing and jewelry from India, preempting rising costs when their biggest overseas supplier revalues its currency. In addition, JC Penney, one of America’s largest department stories, has recently announced that it would double its textile purchases from Pakistan because of improved quality. American manufacturers will thus not see any drastic alleviation of foreign competition even after a Yuan revaluation. Ultimately, a stronger Yuan will prove insignificant in trying to protect US jobs as countries, other than China, are ready to supply goods and services at lower costs than in the US.
• At the urging of domestic manufacturing interests, Congress has threatened to slap heavy tariffs on Chinese goods unless the Yuan rose to more reasonable levels.

• To the extent that speculation has infected the U.S. housing market, a higher Yuan could help to cool things down by exerting upward pressure on mortgage rates.

• Despite nine short-term rate increases by the Federal Reserve since June 2004, bond yields (and therefore mortgage rates) have remained stubbornly low, in part because China needed to buy tons of U.S. Treasury debt to execute its cheap-Yuan policy. By allowing the Yuan to drift higher - and especially by pegging its exchange rate to a basket of currencies, not just the U.S. dollar - there will be less demand for American bonds.

• Given the huge difference in growth rates between the United States and other rich nations, nobody expects the gaping American trade deficit to disappear any time soon. But with the U.S. current account deficit having reached a dangerous 6% of GDP this year, any improvement in the balance of trade could help to avert a currency crisis in the future. Of course, the Yuan’s long overdue revaluation also comes with some risks.

• China's banking system is stuffed with non-performing loans, which could cause financial distress in the context of slower Chinese export growth. In addition, if the dollar declines too much against Asian currencies, the Fed could feel compelled to raise benchmark interest rates even more to head off import-driven inflation.

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The economic fallout from China's scrapping the dollar peg on its currency is likely to be small and most Japanese companies plan to continue to expand business there, according to a survey by a major newspaper.

More than half of the 72 Japanese companies responding to a survey by the Nihon Keizai Shimbun published Saturday said they will beef up their existing marketing and production efforts in China, while none plan to reduce operations because of the Yuan’s revaluation.

Many analysts predict the Yuan will appreciate over time and lift the yen with it — which could hurt Japanese exporters because that erodes their earnings in the United States and Europe when repatriated to Japan. However, a stronger Yuan could also benefit Japanese exporters because it blunts the competitiveness of Chinese exports.

Japan and China have a complex trade relationship, and a rising Yuan would likely affect different businesses in different ways. Some businesses, like discount stores, import products from China to sell in Japan, but other companies have set up plants in China, where they produce cars almost entirely for the Chinese market. Many also manufacture products in China to export them to the United States and other nations.

China remains attractive not only as a low-cost production base but also as a giant market, Japanese business executives say. There may even be new opportunities as Chinese purchasing power increases on the stronger Yuan and consumers' interest in goods imported from Japan picks up.

Still, the Nikkei survey found that 24 of the 72 companies are thinking of expanding their Asian investments to other nations such as India and Vietnam because of the risks of concentrating too much on just China.

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The revaluation of the Chinese Yuan would benefit Pakistan’s exports to China, which shows growth in the recent years, said economic experts in Beijing. However, Pakistan-China bilateral trade that has jumped to over $3 billion last year will receive a marginal unfavorable impact in term of Chinese exports to Pakistan.

"Our exports to China will increase while our imports from there may decline because their products will get more expensive, while the price of our products will remain low," said a Pakistan trader Khalid Mahmood. Pakistan’s current exports to China worth around $600 million are likely to get positive impact. Our products will become more competitive in the local markets; said Commercial counselor Shahid Mahmood It will have negligible impact on overall bilateral trade. When asked to comment on revaluation of Yuan, which is now up by 2 per cent against the dollar, he said prices of Chinese products in Pakistan may go up with a small margin. "However, we are expecting a positive impact on our exports to China,” he added.

A Pakistan businessman Ali Haider said the prices of Chinese goods will be now more realistic and provide level-playing field for Pakistani exporters on global markets. A Chinese exporter Li Yian said "Though it is difficult to say what the fallout will be in the long term, the revaluation of Yuan, coming as it does after over a decade, is a good sign, as China has pegged the Yuan against a basket of currencies this time instead being tied down to the US dollar."

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Effects on China can be studied in relation with the US through the following key points:

Impact on US Interest Rates: Over the past five years, foreign nations, most notably China and Japan, have been stockpiling US treasury securities. China and Japan currently hold over 929 billion dollars worth of US treasury bonds and notes, accounting for nearly half of all foreign-held treasuries and roughly a quarter of total outstanding US debt. For China, whose currency used to be pegged solely to the greenback, this would seem an advantageous move. Having such a large percentage of US treasury bonds in foreign hands has kept both the dollar relatively strong and interest rates at historically low levels. Despite the strong US reliance on foreign creditors, both the government and consumers seem to disregard future consequences and happily continue to borrow enormous amounts of money at favorable rates.

Along with this revaluation, China announced that it would link the Yuan to a basket of currencies and not just to the dollar. Consequently, China will likely decrease purchases of US treasury bonds and rebalance its foreign currency holdings – an action that could push US interest rates higher over time, especially after the inevitable subsequent revaluations take place. The backup in yields could be detrimental to the highly leveraged US economy.
Freeing up Resources: As it gradually frees up the capital that would normally go to purchasing US treasury bonds, China will likely reallocate its resources at home and use a bulk of its capital to build new infrastructure and improve technology. China could shift away from its predominantly export-driven economy; building up domestic manufacturers. Looking at the Solow Growth Model in macroeconomic theory, after an economy reaches its steady state, technological progress is the only factor that can prompt unlimited growth in the production function. When China invests money in improving its factories, production methods, and technology; Chinese factories will become even more efficient and more productive; making Chinese goods even more competitive by driving prices down even lower.

Overall increase in savings: Economic growth and savings rate have a positive correlation; and reasonably so, as it is easier to save money when incomes increases. As China improves its domestic markets, causing a noticeable increase in the standard of living among its people, the savings rate will rise – sparking increased economic growth above the steady state. The benefits China will gain from turning its focus to the development of domestic markets will override the cut back on exports after revaluation. The added emphasis and capital flowing into developing new technology and new production methods will cause a parallel shift upwards in the production function – boosting the health of the Chinese economy as a whole.

A more self-sufficient economy: Despite the general sentiment highlighting the benefits China will gain from improving its domestic market, overcoming the lucrative benefits of a strong export market – quick growth and job opportunities – will be difficult. Focusing instead on long-term benefits, China should start paying more attention to developing sources of domestic demand in order to become a more self-sufficient economy rather than remaining export-dependent. Weaning itself off the need to rely on overseas markets in the future will provide increased stability to the Chinese economy.

China can minimize the negative ripples of further revaluations by making the transition more gradual: first widening the peg over a period of time before allowing the Yuan to free-float. This 2.2% revaluation was so small in scale that it can be seen as the first of possibly many, signaling that future widening of the peg is a likely possibility. China will likely give its economy time to adapt to the revaluation by staying at this 8.11 peg for the rest of the year before making a second revaluation. Since most market observers expected a 3-5% revaluation, the smaller revaluation raises speculation of an incipient second revaluation of similar scale in the coming months. If China had made one large percentage-change revaluation rather than making multiple small percentage-change revaluations over a period of time, it would have had a greater destabilizing effect on the country’s fiscal and monetary policies – lengthening the time needed for China’s economy to recover.

How much time is needed before China might make a second revaluation depends on how quickly its economy can absorb the effects of a stronger Yuan. Revaluing the Yuan before the proper financial structure is in place will signal chaos when existing structures fail to withstand the pressures of a stronger currency. Since a higher revaluation would mean a de facto monetary policy tightening, the situation could have serious repercussions due to the amount of non-performing loans estimated at over 2 trillion RMB, or nearly 15% of GDP. China still has a long way to go before its banking system and the channels to capital formation can bear a flexible currency regime.

Tariffs: Members of the US Congress had threatened to impose tariffs and other restrictions on Chinese goods if a revaluation didn’t take place by year-end. Nonetheless, Congress agreed to hold off on taking any further action on the assumption that China would revalue in the coming months. This revaluation, while greatly symbolic, is nonetheless so relatively small that it will unlikely cause any drastic or immediate economic shift. Although at present, all talks of tariffs are off, will Congress remain pacified with this 2.2% revaluation or will it again use the threat of tariffs to push for a larger percentage-change in the Yuan in the future? Pressing for 27.5% tariffs on Chinese goods doesn’t seem like a very well thought-out threat for the US to give to China. Imposing tariffs and restrictions on China may hurt the US as much as it would impact China, thus not offering Congress much leverage to pressure China with. In fact, tariffs and restrictions would be detrimental to the US; the negative effects of restricting consumer access to cheaper good will far outweigh the protection that tariffs provide to American manufacturers.

In almost all instances, tariffs result in net losses in the economies of both countries involved. An American tariff imposed on China will make Chinese goods more expensive thereby reducing demand for them. Reductions in demand trigger Chinese producers to scale back on production and cut jobs. These job cuts will dampen Chinese consumer demand, thus weighing on the overall economy.

Following this logic, the US should experience the opposite effect: by reducing competition from Chinese imports, sales of domestic US producers and prices should rise; sparking increases in production, employment, and consumer spending. In addition, the US government will generate added revenues from the tariffs, which can be used to benefit the economy. There are, however, large costs accrued from imposing tariffs: an increase in prices, which translates to a decrease in consumer income. With tariffs in place, the price of Chinese goods will naturally go up. At the same time, US manufacturers can raise prices to maximize profits, no longer needing to slash prices in order to compete with Chinese imports. A rise in prices for both Chinese and US goods will eventually restrict consumption in the US. A decline in consumption would eventually weigh on the overall economy.

Tariffs can therefore be seen only as a short-term solution for an enduring long-term problem; masking the need for improved production methods and highlighting the lack of competitiveness of US products on the global market. Despite what American manufacturers say, cheap Chinese goods don’t take away American jobs, but rather take away business from other low-cost countries in Asia and Latin America. Consumption makes up two-thirds of the American economy; so with consumers paying higher prices, imposing tariffs will hurt the American economy more than it would help manufacturers.

Ultimately, tariffs and trade restrictions would strengthen the Chinese economy by forcing it to incorporate large import-intensive infrastructure and become more self-dependent. Moreover, these legislations will carry negative consequences for the US by raising prices on consumers.

Those who will benefit the most from a stronger Yuan will be non-Chinese manufacturers with operations in China. Foreign companies that have china-based production will benefit greatly when their sales are converted from a stronger Yuan back into their native currencies –US retail giants and computer equipment makers that produce from their own factories in China and sell the products back to the US will benefit as the Yuan now buys more dollar. Extensive foreign investments in China over the past decade have all seemed to profit from a stronger Yuan – this increases both the anticipation of a future revaluation as well as the global attention focusing on China at the moment.

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Indeed, the 2.1% Yuan revaluation was smaller than expected. Thus, does the smaller magnitude explain the earlier than expected timing? Did Beijing make this minute change in order to stave off pressure from the US and Europe? A member of the People’s Bank of China monetary policy committee said the revaluation would buy China time to adjust its economy. The central bank chief acknowledged that this was part of a gradual adjustment. In the long term however, when China’s economy is ready for further appreciation, the US will run the risk of seeing falling demand for its Treasury bonds. Many pundits have made the erroneous claim that China will become “absent” from the Treasury market. It is not in the interest of China to start dumping bonds due to the simple reason that such action would have larger than desired upward boost in its currency and drive down the value of its existing Treasury holdings. But a slower pace of US treasury purchases could surely begin to push long-term interest rates higher over time. Such a prospect could be exasperated once hedge funds join in the selling. Rising bond yields could then start weighing on the highly leveraged housing market, which could begin to dampen prices in high construction/high supply regions. Therefore, as a favor to the US, China had better manage its subsequent revaluation in the most gradual, telegraphed manner.

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