China's Currency

China revalued its currency last week, allowing it to rise 2.1% against the U.S. dollar. No longer will the yuan exactly track the buck, as it has for nearly a decade--which has kept the yuan's value artificially low and made Chinese goods cheap in the U.S. Here's what it all means:

Why did China change its currency policy?

Politics mostly. China has a huge trade surplus with the U.S., which has Congress threatening tariffs on Chinese imports. But economics played a role too. China's off-the-charts growth would naturally lift its currency in a free market, which China is trying to achieve. This is a first step toward a free-floating yuan--possibly by the 2008 Olympics in Beijing.

What will be the impact?

A strong yuan will make goods produced in China more expensive. So it will hurt companies like Target, which buys a lot of its goods there and may have to raise prices for the U.S. consumer. But it will help U.S.-based exporters by making their goods more affordable abroad. A stronger yuan should help bring China and U.S. trade into better balance and soothe tensions.

So it's good, right?

If all goes as planned. But a strong yuan may stoke inflation in the U.S., as importers raise prices to protect their profits. There's also a risk that as China bolsters the yuan it will reduce its dollar purchases, which means buying fewer Treasury bonds. That could push long-term interest rates higher in the U.S. and slow the housing market and the economy. But most believe that China, which took forever to go this far, will move slowly enough to avoid these traps. --Daniel Kadlec