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-à-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 expensive 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 expensive American goods. If American consumers do not buy American goods, it means that U.S. producers will post lower profits, leading to wage cuts or labor force cuts that would have to take place in order to compensate for losses.

    So far, it seems that the appreciation of the RMB would help the U.S. get out of the current recession. However, one should not just look at the effects of a devalued RMB, but also at what the cause of this devaluation implies. For China to keep its currency depreciated, it must supply a lot of RMB and buy a lot of dollars. This means that China is one of the biggest investors in U.S. Treasury securities - in other words, China is one of the United States’ biggest creditors. If China is forced to let its currency appreciate, China can no longer lend as much money to the U.S, which would cause long-term interest rates in the U.S. to rise. In a recession, higher interest rates can be catastrophic, because a tightening of the credit market can severely restrict new investment, thereby delaying economic recovery. Furthermore, in a recession, most of the goods and services purchased by consumers are of first necessity, such as food and electricity. Most of these goods and services are produced or provided by American firms, thus, even if the RMB is still relatively undervalued, people would not end up buying many underpriced Chinese goods since these usually correspond to goods of non-first necessity and consumers, who would have already spent most of their income in American goods of first necessity, would not have much income left to spend on underpriced Chinese goods. Thus, American firms that produce goods of non-first necessity and compete with underpriced Chinese goods would not be greatly affected by the RMB’s undervaluation.
Therefore, even though the undervalued RMB does negatively impact the U.S. trade balance and, more importantly, the profits of American firms, these negative consequences are not that important in the case of a recession, because most of the underpriced Chinese goods would compete in markets already deteriorated by the recession, and would therefore not make the recession much worse than before. However, forcing the RMB to appreciate would increase long-term interest rates, which can prolong the effects of a recession in the economy. This ambiguity yields only one conclusion – that to improve the domestic economy, efforts would be better focused on other areas.