The Senate voted yesterday to punish China unless it stops controlling the value of its currency against the dollar. Should the President support the action of the Senate? China began controlling the value of its currency around the time of the Asian Financial Crisis in the 1990s. The financial crisis was spreading from country to country in Asia, leading to major devaluations of exchange rates, beginning in Thailand before eventually stopping with China. Most supported China's policy at that time. Over time, as China became a top exporter, the policy became more controversial as other nations saw it as a way of ensuring China's exports were cheap (and thus a threat to producers in other countries). In 2005, China began to allow its currency to gradually increase in value, resulting in a 30% increase in the value of the renminibi between 2005 and the present, pausing for a period of time during the global financial crisis before resuming the policy of gradual increases in 2010. How does China control its exchange rate and how does it affect China and the rest of the world?
China's currency (known by two names, the yuan and renminbi) can be exchanged for other currencies, thus its value is determined in the foreign exchange market (supply and demand). If China thinks its currency is increasing in value too quickly, it will sell yuan in the foreign exchange market and buy US dollars (or possibly some other currency). Rather than just buying dollars, its central bank buys US government bonds (or recently, bonds of various European governments as well). Selling yuan/buying dollars causes the exchange rate value of the yuan to be lower than it otherwise would be in terms of dollars. Meanwhile, the Chinese central bank accumulates a large amount of US government bonds. A significant impact of these bond purchases is that US interest rates are lower than they would have been had the Chinese central bank not have loaned the US government money (i.e., bought US bonds). Thus the US economy benefits in terms of lower interest rates.
Most people think that the US buys goods from China, but China doesn't buy US goods. However, China is the #3 destination for US exports, behind Canada and Mexico, with exports to China growing rapidly during the last 5 years (more than 20% per year other than the recession years of 2008-2009. In fact, China buys more US exports than Japan and Germany combined (July 2011). Of course US imports from China far exceed our exports to China, resulting in trade deficits with China typically in excess of $200 billion per year. However, China tends to run trade deficits with the rest of the world (excluding the US). Why does the US run trade deficits with China while the rest of the world does not? Two reasons stand out; first, the US economy is very consumer-oriented while the Chinese economy is very producer/export oriented. Second, the manipulation of the Chinese currency. In the past China linked its currency only to the US dollar and, while it has modified that policy in recent years, it still links its currency primarily to the US dollar. Thus the Chinese currency is undervalued in terms of the dollar more so than other currencies. As a result, China's trade with the US is distorted more than its trade with other countries.
It's in China's interest to move towards a freer currency, reducing the amount of control that it exercises over time. A stronger yuan would benefit Chinese consumers by increasing their global purchasing power while also re-orienting the Chinese economy away from an overdependence on the global economy and towards its growing domestic market. In fact, the leaders of China have set this as one of their priorities in the coming years (one of the goals in its current 5-year plan is to increase domestic consumption). As the Chinese central bank slowly shifts away from a policy of buying US bonds as a means of controlling its currency, the US government will need other sources of funds to finance its budget deficit or risk significantly higher interest rates (unless it enacts policy to get the budget deficit under control).
Should we risk a trade war with China (US puts sanctions on China and China retaliates) to try to stop it from controlling its currency? It's never a good time for a trade war, but especially not now, given the fragile state of the US and global economy. A change in China's exchange rate policy, resulting in a stronger yuan, seems likely, since it's in China's interest. Though US exporters may benefit, higher interest rates in the US resulting from the change in policy will mean that there will be losers as well as winners in the US due to China reducing the manipulation of its currency.