Breaking the Peg

For the past several decades, the Chinese government has attempted to boost its exports through a policy of undervaluing its currency. They used an artificial currency peg in order to stabilize the value of their currency, the renminbi (also known as the yuan), in comparison to the US dollar. They pegged the renminbi below its market value in order to make their goods cheaper on foreign markets and thus to increase demand for their production.

The Chinese have pursued their peg through a fairly complex policy of buying dollars from their citizens after they sell goods to the United States, then issuing yuan denominated debt and purchasing dollar denominated debt. In essence, they are taking dollars from their people, giving them back renminbi and buying debt from the American government. The net effect of this is to flood their domestic markets with yuan while pulling dollars out of their economy. This makes the dollar relatively expensive in relation to the yuan. The artificially cheap renminbi allows their goods to be relatively inexpensive on foreign markets, and this results in greater demand for Chinese goods. They constantly have a new supply of dollars as their factories sell goods to US companies and then sell the dollars back to the government.

However, this policy may soon be changing. A Chinese central bank governor recently signaled that they may un-peg their currency. He said that they would not be maintaining their current monetary policy 'indefinitely' and that they may allow their currency to float in order to speed up economic growth. The bank has gone so far as to study the potential effects of ending the peg.

Any move to end the peg would have huge effects on the world's economy. First, by increasing the value of their own currency the Chinese would make their goods more expensive in foreign markets. Likely, this would tamp down some of the huge demand for their production. However, the Chinese would likely replace the demand by selling more of their goods domestically. For foreigners, like Americans, this would probably cause the prices of many imported goods to rise. Gone would be the days where imported goods could be sold for a fraction of domestic ones. This might be inflationary for the US, but could likely give some support to the domestic manufacturing industries.

Other major affects would likely take place in the world's financial markets. The huge surplus of dollars the Chinese currently enjoy would likely dry up. This may cause them to purchase less foreign debt. This could force interest rates in the United States to rise as the government finds fewer major borrowers for Treasuries. Additionally, the Chinese would have less currency to invest in foreign companies. This might cause stagnation in the price of financial assets.

The effects of ending the yuan-dollar peg would be many. The Chinese government would cause their exports to decrease by making them more expensive. Such a move might help workers in the US as domestic production would be able to better compete with cheaper imports. However, this would come at a price. The price of goods would likely rise causing inflation. Additionally, such a move would force interest rates to increase making it more difficult to borrow money and issue debt.