Cash Management

Freeing the Yuan

After nearly two years of being pegged to the dollar, China's currency is beginning to float again.
Kate O'SullivanJune 23, 2010

Last weekend the Chinese government announced that it would again allow its currency, the yuan, to float more freely in relation to other world currencies, after nearly two years of being pegged to the dollar. China will implement a so-called crawling peg, in which the yuan’s value is tied to a basket of other currencies.

Global stock markets greeted the news with an initial burst of enthusiasm, with traders interpreting the move as a sign of confidence in the global economic recovery. The United States and other governments around the world have been heavily pressuring China to take the step in recent months, arguing that the dollar peg gave China an unfair advantage in global trade and contributed to trade imbalances.

For the many U.S. CFOs whose companies manufacture goods in China, the move changes the currency-risk picture, as the yuan (also called the renminbi) is widely expected to appreciate against the dollar, making manufacturing there more expensive than it has been in the past. Indeed, the yuan rose 0.4% on Monday, a modest gain that brought the currency to 6.7976 yuan to the dollar, its highest level since it has been regularly traded. China’s central bank has insisted that any appreciation will be gradual, however, and the currency weakened against the dollar on Tuesday.

“It sounds like it’s going to be a very limited change,” says Richard Marston, a professor of finance and economics and director of the Weiss Center for International Financial Research at the Wharton School. “The Chinese government hasn’t said anything about how much they will allow the currency to appreciate, but I expect it to be very, very measured.” Marston points out that between 2005, when China first allowed the yuan to begin gradually appreciating, and 2008, when it pegged the currency to the dollar to provide some stability in the face of the global financial crisis, the currency appreciated just over 5% per year.

While U.S. finance chiefs will be monitoring the currency shift, Marston says there is much less currency risk versus the yuan than versus the euro at this point. “The Chinese economy is so competitive that the renminbi can only go up,” he says. “So it’s a one-way bet, and the chances of a jump are relatively small.” In contrast, the euro has swung wildly in the past two years, from 1.25 to the dollar during the peak of the economic crisis to 1.50 in late 2009, to as low as 1.19 earlier this month.

Over time, the yuan’s appreciation will mean that Chinese businesses will compete more directly with the United States and Europe on higher-end products, says Marston, as the currency’s strength will make Chinese exports less competitive in markets for lower-margin products such as toys, shoes, and textiles, where China currently dominates. “It’s a wonderful thing for China to allow the market to have more impact on its currency, because the imbalance that is building up is really hurting the world market,” he says. “China has become much more competitive with Mexico and other countries in Latin America, and it is really hurting them.” The yuan’s appreciation is also good news for Vietnam, he adds.

As for U.S. companies, says Marston, the floating yuan “will affect the labor-intensive industries where the U.S. really doesn’t compete. Later on we’ll be competing with the Chinese in a lot of areas, but that’s down the road.”