Pressure is building on China to revalue or abandon its currency peg to the U.S. dollar. The rapid rise in the U.S. trade deficit with China driven by the explosion of imports has led many U.S. manufacturers, politicians and trade officials to press China to allow its currency (RMB) to appreciate. Critics claim that the currency peg ($1: RMB 8.28) preserves Chinese cost advantages relative to exported U.S. goods, thereby contributing to the growing trade deficit. Senior Administration officials are pressing their Chinese counterparts hard to revalue, while Congress is considering a host of legislative actions aimed at turning up the heat. Rapidly rising foreign currency reserves and concerns over inflation too have resulted in economists inside and outside of China recommending such a course. Possible revaluation scenarios and the ramifications on U.S. business are outlined in this client alert.

Political Considerations of Currency Revaluation

There are political considerations to bear in mind between the various revaluation approaches for China. It seems probable the International Monetary Fund (IMF) would endorse tying the RMB to a basket of currencies, whereas the U.S. Treasury would prefer a more free-floating, market-oriented approach. As a result, if China moves to a basket it would considerably diminish international pressure primarily from the IMF to revalue reducing the significance of demands from Washington. This would add to the political attractiveness of the strategy from China’s perspective.

What Will China Do?

In terms of a reaction to U.S. revaluation demands, China’s signals have been mixed. Some maintain that the Chinese won’t consider bowing to U.S. demands, regardless of how politicized the issue becomes in the United States. Others see signs that China is preparing to lessen its tight reign on the currency regime. For example, the Peoples’ Daily (the official government newspaper), recently published specific revaluation plans only to retract the story shortly thereafter. The motives are unclear, but many speculate it was the Chinese government’s way of evaluating the appetite for such a change.

The Chinese, too, have some economic interests that would be served by allowing the RMB to appreciate; most notably controlling inflation. All factors combined, many observers speculate that a change in Chinese currency policy is likely within the next six months.

What Are the Likely Revaluation Scenarios?

When China finally begins to address the RMB peg to the dollar, many speculate that the Chinese central bank will pursue a slow transition away from the peg revaluation in the range of three-to-ten percent followed by an immediate peg to a basket of currencies (as opposed to the current peg to the dollar). In the view of Chinese officials, directly floating the RMB bares too much uncertainty and could have catastrophic effects on their economy, whereas tying the RMB to a currency basket balances that risk. For this reason, moving from a peg to the U.S. dollar to a basket of currencies is more likely than a short-term move to float the RMB.

A Chinese currency basket would likely be comprised of the currencies of China’s main trading partners: the U.S., Japan, the E.U. and Hong Kong (or the dollar, yen and Euro). Under this scenario, a basket would still track the U.S. dollar quite closely, since it would give heavy weight to the Hong Kong dollar, which is held equal to the U.S. dollar. A regional example is Thailand whose currency basket for the Thai Bhat was thought to be as much as 90 percent weighted to the dollar.

Effects of RMB Revaluation

While it may help defuse some political tension, a relaxed peg is likely to have limited impact on the U.S. trade imbalance with China. Even a 25 percent revaluation (which seems out of the question) is projected only to reduce the current account deficit by five percent or less. An appreciation of the magnitude discussed above (10 percent) would likely lead to no more than a $10 to 15 billion improvement in the U.S. trade balance with China. Further, some of the benefit will be reaped by Malaysia, Mexico and other countries that compete with China rather than by U.S. manufacturers. While a change of this magnitude could have an important competitive impact in some sectors, generally revaluation will be of limited consequence to the U.S. and U.S. businesses.

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