Be careful what you wish for
I think the short-term impact of this change is instructive. Following the announcement, the yuan rose 2% relative to the dollar. More importantly, the interest rates which drive the mortgage market rose 11 basis points from 4.16% to 4.27%. The latter effect could help burst the many “mini bubbles” in the US housing market.
In the longer-term, the impact of devalued Chinese currency is complex. On the surface, the devaluation would make it more expensive to import goods for China to the US and cheaper for Chinese to buy US products and services. China's trade deficit with the U.S. could easily top $200 billion by the end of 2005, 20% higher than 2004’s deficit. And it looks like China’s global trade surplus -- which in recent years has been a modest $30 billion or so -- could jump to $120 billion in 2005. In theory, a floating yuan might reduce the trade deficit between the US and China.
But China is also a big holder of US debt. Specifically, China holds $700 billion in foreign currency reserves, 70% of which are in dollar assets like U.S. Treasuries. If the Chinese are getting their interest payments in dollars, then those dollars are worth less to Chinese debt holders than they were before. So China could either hedge these dollar based interest payments or start to demand higher US interest rates to offset the impact of the weaker dollar relative to the yuan.
And the impact of China’s currency moves could affect Japan’s purchases even more since China – with $190 billion in US Treasury holdings -- is only the second-largest holder of Treasury securities after Japan, with $243.5 billion. If the mysterious basket of securities against which China is allowing the yuan to float includes the Euro, it is possible that China and Japan will decide to shift more of their spare cash into Euros or other currencies and out of the US dollar and its debt.
In reality, China will probably try to control tightly the change in the relative value of the yuan to the dollar. Because of that, I suspect the impact of the change will be mild in the short run. China does not want to trigger any big problems for its own economy by letting its currency rise too quickly in value. Nor does it want to induce a slowdown in the US economy since that would lessen the exports of Chinese-made goods.
But hedge funds and currency traders are likely to bet that the dollar will weaken relative to the yuan over the long run. Depending on the magnitude of these bets, the 10-year treasury could yield a lot more than it does now which would accelerate the bursting of the housing bubble, slow down US GDP growth, and accelerate inflation by raising the cost of Chinese-made goods to US consumers. Whether China would offset these negative effects by importing cheaper US goods remains a mystery.