While everyone is celebrating the news that the Chinese government has decided to let its currency to revalue I'm still skeptical about it.
Since 2005, China has been under tremendous pressure from the US to revalue its currency as the US blamed China for causing the US high current account deficit with cheap influx of the Chinese goods. Hence, in July 2005, the RMB was revalued to 8.11 per US dollar, which was a mere 2% increment (Prior to that the Yuan was pegged to the US dollar at 8.27 from 1997 to 2005). Since 2005 the Chinese yuan was unpegged and allowed to float within a narrow band of 0.3% - 0.5%. However, in 2008 due to the financial crisis around the world, the Chinese Central Bank has manipulated their yuan to the dollar of around 6.90. Until recently, the Central Bank of China has announced to further revalue their currency through a more flexible exchange rate policy, how 'flexible' we do not know as there was not much information given.
According to the Big Mac Index, Renminbi was undervalued for nearly 50%! Hence I really doubt the China is going to let its currency to reflect its true value, the most I would predict is another 5% appreciation, no more! Why? As it makes no sense for the Chinese yuan to be so strong for the following reasons:
1. Chinese Exports
According to BBC, Chinese exports value has reached US$1.2 trillion which make China to be probably the no.1 exporter in the world. They export mostly electrical goods, textiles, and many low-valued daily products like tooth brush and under garments. These products are the driver for the economic growth in China, for the past decade, it has recorded tremendous growth of 6% to 13%, it will soon overtake Japan to be the Asia largest economy.
2. Job opportunity
Due to the cheap goods demanded by the whole world including you and me, it has contributed to their income and employment, improved their standard of living, and most importantly the influx of foreign direct investment (FDI) into China.
3. Foreign Direct Investment
Since 1980, the FDI has been increasing by an exponential rate, which can be seen from the graph. In the beginning when China first open its door to the world, it was the Taiwanese and Hong Kong factories went over there to set up their operating plants. Later when China joined the World Trade Organisation WTO more capital from all over the world came to capitalise on the China's cheap labour. These valuable foreign direct investments and exports has turned China to be the second largest economy in Asia.
Value of Yuan
The value of a currency is usually reflected based on a country's economic performance, which is reflected on its Balance of Payment. Over the years, while many western countries like US and EU countries are experiencing deficits in their balance of payments, China has surpluses year after year. Hence, by right we should be seeing depreciation of those western countries currency (which is happening now) and an appreciation of the yuan. But yuan has been relatively constant at around 7-8 per US dollar over the years! Clearly, the yuan has been artificially kept low by their Central Bank.
So, what's the big deal? If it's not a big deal then why should US kept barking on the China to appreciate their currency?
Let me explain further. First when Chinese yuan suppose to reflect its true value but it didn't then we will continue to see China exports continue to sell at low price to its trading partners like US, make them keep buying the Chinese goods and worsen the US deficits further! Hence, if the yuan is stronger, the US will import less Chinese goods and thus their balance of payment shall improve.
The currency war between the US and China has been long, and it will continue to stay if the yuan continues to be undervalue against the greenback.