Conventional wisdom held that the Chinese currency, the yuan, was undervalued. Alleged proof consisted of the large international reserves held by the People’s Bank of China (PBC) and the country’s trade surpluses. Announcement of the slight revaluation of the yuan on July 21 seemed to validate this view of the exchange rates.

American manufacturers and exporters have long sought a revaluation, or increase in the value, of the yuan against the dollar. The Chinese, however, hesitated, and not solely because of a desire to protect their country’s export position. Besides a possible increase in export prices, a revalued yuan could hurt foreign investment into China. Asset prices in the appreciated yuan now cost more in dollars, and servicing of existing operations in China now requires more dollars. The Chinese, even with large national savings, depend on foreign investment for technology transfers. Another reason for the reluctance is the large percentage of the country’s bank assets that are bad, with estimates higher than 20 percent for the percentage of assets in default. With a stronger currency, funds in Chinese bank deposits (which are the banks’ liabilities) could shift overseas now that a given amount of yuan will acquire more dollars. Banks would then need to liquidate assets to pay these depositors and a banking crisis would ensue if assets decrease at a faster rate than do liabilities.

The PBC’s large holdings of foreign exchange reserves may not be evidence of a cheap yuan strategy. Much of this accumulation of these reserves results from the selling of yuan to finance inflows of short-term foreign capital, much of it for speculation; that is, the PBC would sell yuan cheaply for dollars to speculators, who hold on to the yuan until a significant revaluation, and then sell them back for more dollars. This is the opposite of the British case in 1992, when speculators sold pounds to the Bank of England for dollars, then, after the pound’s devaluation, retired liabilities denominated in pounds with fewer dollars, keeping a portion of the dollars bought from the Bank of England as a return to speculation.

The extent to which the exchange rate of the yuan has negatively impacted American manufacturing is unclear. In 2004, China provided about 13 percent of imports to this country while the U.S. trade deficit in manufactured goods was over $550 billion. Accounting for these facts suggests that the stronger yuan will not increase the amount of American-made goods on U.S. retailers’ shelves. Likely, if goods that are now produced in China, which usually involve large quantities of unskilled labor, increase in price, they will be undercut by exporters from labor-abundant developing countries whose currencies have not appreciated against the dollar. Considering, however, that China’s exports use a high content of imported inputs means the effect of the stronger yuan in making these inputs cheaper for Chinese manufacturers will at least partially offset the stronger yuan’s effect of making Chinese labor more expensive in dollar terms. The results for the prices of coffee-makers and toys are not clear.

In summary, the revaluation of the Chinese currency will not significantly impact American consumers or American manufacturers servicing the domestic market, though this could change with additional revaluations of other Asian currencies. Continued revaluation will make American goods cheaper for Chinese buyers and could result in more American exports. Also, more Chinese purchases of American assets, in a manner similar to the Japanese buying spree in the 1980s, could accompany a sustained revaluation, meaning the recent Unocal story is only a beginning.