South-Western College Publishing - Economics  
Will China Float The Yuan?
Subject Chinese Currency
Topic International Trade
Key Words

Peg, Yuan, Float, and Trade Deficit

News Story

Economists around the world expect China to release its tight control of its currency, the yuan, so that the yuan floats according to worldwide market conditions instead of pegging the yuan's value to the U.S. dollar-a policy that the Chinese central bank has maintained since 1998. The U.S. has lead the charge calling for reform. U.S. Secretary of the Treasury John Snow reported to Congress last week that the Bush administration's two-year effort pressuring China to stop pegging the yuan so tightly to the U.S. dollar is now showing results.

A cheaper yuan makes U.S. products more expensive for Chinese consumers and makes Chinese products less expensive for American consumers. China's stubborn pegging policy has created a growing U.S. trade deficit with China.

American manufacturers have long blamed the Chinese practice of pegging its currency values for continually increasing trade deficits and with a loss of U.S. manufacturing jobs. America's trade deficit with China reached $162 billion last year-approximately 26% of a total U.S. trade deficit of $617 billion. Both numbers represent record highs and contribute to the U.S. growing pressure for reform.

Some analysts contend that China's long practice of pegging the yuan to the U.S. dollar has resulted in the Chinese currency being undervalued by as much as 40 percent. This discrepancy gives China a huge advantage in the world marketplace and makes it very difficult for American and other countries' manufacturers to compete.

Secretary Snow reported to the Senate Banking Committee that the Chinese government has been preparing to loosen the tie between the yuan and the dollar. The reform will not likely be a complete release of the peg, but a gradual move towards a full float-a position in which the value of the Chinese currency will be determined based on supply and demand in global currency markets.

"We are not calling for an immediate full float with fully liberalized capital markets. This would be a mistake at this time-- China's banking sector is not prepared," Snow said. "What we are calling for is an intermediate step that reflects underlying market conditions and allows for a smooth transition--when appropriate-- to a full float."

Questions
1.

Discuss what pegging a currency means. Who benefits from this system of currency valuation?

2. Explain the meaning of the term trade deficit.
3. Define the economic concept of a fully floating exchange rate. Who benefits from fully floating exchange rates?
Source Associated Press, "Treasury Secretary Snow Says China Must Change Currency Policies," The New York Times Online, May 26, 2005.

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