Critical Analysis: The Rmb's Exchange Value

IN 2005, CHINA ENDED its policy of maintaining a firm exchange rate for its currency, the renminbi (RMB). Instead of being pegged to the US dollar, the RMB was now going to be allowed to float with respect to a basket of currencies chosen by the Chinese government. This would allow the RMB to artificially replicate a fully free-market floating currency. However, the RMB was not to be allowed to move completely freely - it could only float about 0.3% around a central parity estimate given by China. This band was later increased to 0.5% in 2007. Despite this seemingly small floating capability, the RMB has appreciated about 21% since 2005. In spite of this appreciation, several American politicians still argue that the RMB is undervalued and, in the midst of a financial crisis, they are turning their eyes to China to find an easy escape from a recession. They want China to appreciate its currency so that US products can perform better in both domestic and international markets, which they argue would alleviate the recession by increasing production. However, the truth of the matter is not as simple as portrayed. As in any open economy, imports flow into the country and exports flow out. Currency markets both regulate the value of a particular country's currency, and affect the scope of trade that flows into and out of a particular country, depending on how that country's currency is faring vis-a-vis those of others involved in the market. Consider how an American manufacturer would be affected by currency fluctuations. If the dollar is valuable in comparison to other currencies like the RMB, then fewer American goods will be exported to China. Furthermore, an American dollar means the RMB is relatively cheap, meaning that American consumers will be encouraged to spend large sums of money on Chinese goods to derive more utility out of a fixed number of dollars. In essence, the dollar's purchasing power has increased, allowing American consumers to buy more than they ever would, but the allocation of most of their money outflow in terms of consumption goes to China - ultimately meaning that dollars are flowing out of the United States. This would benefit China at the long-term expense of the U.S. Chinese producers would reap great profits (but American producers would not) because first, no one would buy expensive American products domestically, and second, foreign countries would have no reason to purchase American goods. …