China's Yuan Move: How Much Does It Matter?

China's weekend decision to allow its currency to appreciate against the U.S. dollar is rippling through international markets. Asian currencies are up in hopes that as the yuan gains purchasing power, the Chinese will spend more on imports. U.S. borrowing costs rose slightly, perhaps because when the yuan rises against the dollar, China needs to buy fewer dollars, which reduces the demand for Treasuries.

But what we're talking about is a .42% increase against the greenback. China still depends on exports, which benefit from a cheap yuan. With global market weak, the government won't punish its exporters by making their products more expensive through drastic appreciation. So what should we expect in the short term? To get some perspective on what China's move means, I spoke with Philip Levy, an economist at AEI. An edited version of our conversation follows:

The U.S. government sounds pretty pleased with this move. Why?

The U.S. government took a big risk. We called the Chinese out on manipulation earlier, and they weren't moving. You've had pressure mounting through the spring to make this announcement on Chinese currency manipulation. [Rep.] Sandy Levin warned the administration, he said they'd better have results by the end of June before the G20 conference. It was looking like a long shot.

So those are the optics [politically]. What are the substantive reasons for why we wanted the Chinese to increase the value of their currency?

There's a mix of policy reasons, both benign and less benign. When you talk about rebalancing the global economy, which is a G20 goal, you talk about pulling away the wrench in the spokes. The Chinese currency peg was a big wrench. Now China gets flexibility with its currency.

The Chinese have been saying for a long time that they plan to do this. They have their own domestic reasons. They're worried about inflation, too much money coming in. Appreciating the currency fights inflation. They are getting control of their monetary policy.

What's the other argument for how this move could help the United States?

There are some prominent voices linking Chinese currency practices to the trade deficit and job market [Quick and dirtily on the trade deficit: higher currencies against the dollar makes U.S. goods cheaper to buy, boosting our exports, closing the trade deficit, profiting businesses, and, finally, leading to jobs].

But normally economists are really skeptical about trade deficits and the rate of economic growth. We've had full employment with big trade deficits before. We had an experience with significant revaluing in China in 2005, and the trade deficit grew. More goes into Chinese consumption than the exchange rate. My guess is we might see up to six percent [appreciation] a year, and that's half a perecnt a month, but we're not going to get many jobs because of it.

As I understand it, the long-term hope is that the world needs another engine for demand especially with the U.S. economy limping and our consumers emerging from under a pile of debt. Is the hope that a stronger China with a more valuable currency can be that second major engine?

It's the hope. But it's difficult. It requires a bunch of changes in Chinese societies beyond currency. The more measured response is this looks like one step in the that direction.

So we can't expect the currency to appreciate quickly.

Right. I don't think we're done with our troubles with the euro. China has appreciated 15% against the euro, which is more than they want. Too much appreciation too quickly could actually have devastating impact on Chinese economy and lots of unemployed people.

Because export-dependent businesses will be in trouble?

Yes. A lot of these are low margin businesses. They're not raking in huge profits, maybe 3 percent 3 percent profit margins. They won't stand a 25 percent currency appreciation. And lots of unemployed people hurts consumption.