China Releases the Dollar Peg

The People’s Bank of China, China’s central bank, announced over the weekend that it will resume a gradual appreciation of the RMB against the U.S. dollar, and that it will manage the yuan’s exchange rate with reference to a basket of currencies, rather than pegging it to the dollar. The PBOC statement makes it clear that the currency will move only very gradually. Along with most economists, Andy Rothman, China Macro Strategist for CLSA Asia-Pacific Market, expects appreciation to return to the 5 to 7 percent pace of the 2005-2007 period.

Contrary to what Secretary of the Treasury Timothy Geithner and the politicians in Washington might think, the unhinging of the RMB from the dollar is not necessarily a good thing for the American economy.

For starters, the gradual appreciation of the RMB against the dollar will not create enough new jobs in the United States to have any material impact on the country’s unemployment rate. At the margin, some American products may become more competitive due to a more highly-valued yuan, but the jobs most affected in China — those with high labor content — are unlikely to move to the United States. Instead, they will move from factories in China’s coastal areas to factories in the country’s inner provinces where costs are lower, or perhaps to less developed countries with even lower wage rates.

In the meantime, China’s manufacturers will continue to do what they have been doing, and that is to move up the value chain to manufacture more highly value-added products where raw materials and engineering design are the most important cost components. Chinese manufacturers will be able to purchase raw materials more cheaply with a more valuable yuan, and higher value-added products take greater advantage of China’s vast pool of low-cost engineering talent. As a result, Chinese products will continue to be very competitive with those manufactured in the United States.

From 2005 to 2008, when the yuan appreciated by 20 percent against the dollar, China’s exports to the United States increased by 40 percent. That’s because a more highly-valued yuan meant that Americans had to pay more for the products that they bought from China, and the composition of China’s exports to the United States began to change. I expect the same to happen this time around.

Also, the RMB peg to the dollar has provided much-needed support for the dollar as China has had to buy U.S. Treasuries and other dollar-denominated assets to maintain its targeted exchange rate. This is one of the factors that has enabled the U.S. government to finance large deficits with no increase in interest rates. At the margin, China will now buy fewer Treasuries and dollar-denominated assets than they would otherwise, in favor of assets denominated in other currencies such as the Euro. The net effect will be higher interest rates and higher inflation for the U.S. economy.

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