China recently decided to start reforming the Yuan exchange rate and make it more flexible, although at a very gradual rate. They want to keep the rate stable and plan to return to the managed “float” that traded the Yuan in a very narrow band against other currencies. When this policy was in place in 2005, the Yuan appreciated 21% over 3 years compared to the dollar. Although China generally tries to limit appreciation this policy will give them more control over exchange rates and help to prevent rapid changes.
A more rationally determined Yuan helps make the adjustment from an investing and exporting economy to one based more on domestic demand. It will also help control inflation and help China to be more dominant in global trade and finance. The loss of exports will most likely be minimal and the Chinese economy will be rebalanced.
These changes have met with mixed projections from economists. Some say that this new flexibility is a good thing for China’s economy. However, until they allow their currency to float freely there will be challenges to its value and its role in the world economy will be limited. Others project the Yuan to a more prominent role in the currency market because of its stability and controlled value.
China’s Central Bank also plays a role in the future of the Yuan. Its three US branches recently adopted a policy that allows Americans to open accounts and buy up to $20,000 Yuan annually. This is bound to improve China’s economy and thus, the value of the Yuan.
China allowed the Yuan to appreciate about 2% against the dollar last July, the beginning of a carefully controlled rise that will take place over the next couple of years. Many experts feel that this step was taken in order to dominate the foreign exchange markets. China has the second largest currency reserves in the world second only to Japan. Their $700 billion reserve consists mostly of dollars, which gives China a lot of influence in the world’s foreign exchange markets. So when China begins to manipulate the value of its currency it can be felt in financial markets around the world.
There is another reason that China is becoming more flexible with its currency, of course. Its growing market influence means that companies may no longer voluntarily conduct most of their trade in dollars. As the Yuan grows stronger they may insist that they be paid in that currency. This would be very advantageous to China and increase its influence in global trade and the world economy in general.