The Yuan Effect

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r the past year, wild speculation and furious debate have turned the future of the Chinese currency, the yuan, into the hottest and most polarizing topic in the global economy. Pegged to the U.S. dollar since 1994—meaning that when the value of the greenback rose or fell, so did the yuan's—China's currency had come to embody the industrialized world's fears of a hypercompetitive mainland staging a hostile takeover of global manufacturing. Led by the U.S., critics accused China of clinging to the dollar peg in order to keep the yuan artificially weak, making its exports extra cheap and fostering a worrisome trade gap with the U.S. that ballooned to a record $162 billion in 2004. Unless Beijing changed its currency policy, a trade war loomed. Still, Beijing wouldn't budge, leaving businessmen and investors across the globe guessing as to when this uneasy status quo might finally change—and how dramatically.

Although considerably more muted than expected, the answer came on July 21, when the People's Bank of China posted a notice on its website announcing the end of the yuan's peg to the dollar. Citing its wish to "improve the socialist market economic system in China," the bank set the yuan at 8.11 to the dollar—a 2.1% increase in its value—and decreed that henceforth it would trade within a narrow band of 0.3% each day against a basket of (unnamed) currencies. Now that the yuan is allowed to float, even only slightly, its value should better reflect China's buoyant economic growth and its booming trade with the rest of the world. But the 2.1% shift is so slight that it amounts to little more than "a toe in the water," says David O'Rear, chief economist at the Hong Kong General Chamber of Commerce.

Indeed, financial markets greeted the change without a fuss. But much like the famous butterfly of chaos theory, which flaps its wings in Brazil and sets off a tornado in Texas, Beijing's decision portends momentous consequences for the global economy down the road. Scrapping the dollar peg is widely seen by economists as the first step toward a free-floating, and much stronger, yuan. If the yuan continues to appreciate, China's new currency policy could reorder global trade and investment, boost the power of Asian consumers, and address global trade imbalances. U.S. Treasury Secretary John Snow, who had been a vocal critic of Beijing's peg, said "full implementation" of the new policy "will be a significant contribution toward global financial stability."

Snow was not the only one to applaud. China's move received qualified praise from Bangkok to Tokyo to Washington, where U.S. Federal Reserve Chairman Alan Greenspan called it "a good first step." It's unclear whether Beijing acted because of American pressure or in spite of it. Zhou Xiaochuan, head of China's central bank, said the shift was made because the dollar had become too volatile, so it was in China's own long-term interest to change. Whatever the reasons, the decision is expected to smooth strained relations between China and the U.S.—good timing, given that a meeting in Washington between Chinese President Hu Jintao and U.S. President George W. Bush is scheduled for September.

Temporarily, at least, the announcement should also placate hawkish politicians in the U.S. and Europe who were lobbying for protectionist measures to stem the tide of Chinese imports. Legislation in the U.S. that would have imposed a 27.5% tariff on all Chinese imports if Beijing didn't revalue—a measure that received an unexpected level of support in the Senate earlier this year—now appears to be going nowhere. Also easing anti-Chinese sentiment in the U.S. were setbacks last week to two attempted acquisitions of U.S. firms by Chinese companies. Mainland appliance maker Haier dropped its $1.28 billion offer for Maytag, and a politically controversial $18.5 billion bid by China National Offshore Oil Corp. to buy U.S. oil giant Unocal has run into stiff headwinds after Unocal's board voted to stick with an improved offer from American company Chevron. Revaluing the yuan "buys the Chinese significant political capital," says Hong Kong-based Merrill Lynch strategist Spencer White.

But at what price to the Chinese economy? China had resisted ending the peg partly out of fear that its factories would become less competitive, which would cost the country jobs and curtail growth in its export-fueled economy. Officials for Chinese companies that compete almost entirely on price, such as those in the toys and textiles industries, say even this 2.1% increase in the yuan's value will hurt sales to cost-conscious U.S. retailing giants such as Wal-Mart and Target. Yu Zhihua, export manager for the Hangzhou Silk and Garment Import Export Corp. in Hangzhou, says her profit margins are so thin already that she can't afford to lower prices to offset the 2.1% difference in currency values. "We expect contracts that would have gone to us will switch to Bangladesh and Indonesia," Yu says.

Indeed, Deutsche Bank estimates that a 5% appreciation of the yuan would slice 5-10% off the profits of China-based textile and electronics exporters, because they have narrow margins and little power to adjust their prices. The pinch will also be felt by the many foreign companies operating mainland factories. Tony Cheng, a Taiwan businessman who runs a factory in Shenzhen making Christmas ornaments, calls the revaluation "a big blow."