For the past decade, China has been the world's fastest-growing economy, lifting millions out of poverty and creating an industrial powerhouse producing virtually everything from toys and clothing to the most advanced microelectronics. And not coincidentally during the same period, China pegged the value of its currency to the U.S. dollar, which encouraged foreign investment and made its exports more competitive on world markets.
But last week, under outside pressure from the United States and internal pressure to slow runaway growth and hold down the money supply, China announced it was ending the dollar peg. Instead, the value of the yuan will be tied to a basket of currencies that will remain a secret, effectively allowing the government to set the value anywhere it wants. On the first day, the dollar fell 2 percent against the yuan.
The move was immediately hailed by Treasury Secretary John W. Snow as a victory for his private and patient financial diplomacy over the past two years, even as manufacturers and members of Congress pressed for stronger measures. And while the 2 percent move, by itself, will have little impact on the huge trade deficit with China, Snow and others predicted the Chinese would allow the yuan to rise gradually, perhaps by as much as 10 percent over the next year. Critics, who argue that the yuan is now as much as 30 percent undervalued, complain that even 10 percent would just keep pace with China's rapidly rising productivity.
One immediate effect of China's move was to push up the value of other Asian currencies, which had also been kept artificially low. In the near-term, it could also prompt Chinese who have illegally stashed their wealth in dollars overseas to bring it home before its value is eroded by a further decline in the dollar.
While the dollar peg has been immensely beneficial to China's development, it has not been without cost. While it helped create millions of badly needed export jobs for Chinese workers, it also robbed those workers and their companies of the full value of their labors by underpricing their products. And to maintain it, the Chinese central bank not only had to let the supply of yuan grow to inflationary levels, but it also wound up with $650 billion in dollar reserves that are now likely to decline in value.
Here in the United States, any significant decline in the dollar should help slow the runaway growth of imports. But it will come with a price: higher inflation, slower export growth and rising interest rates as China reduces the volume of Treasury bonds it buys with all those dollars piling up in its central bank. With so much at stake, and the current imbalances so large, it may be a good thing that the Chinese are taking things nice and slow.