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To simplify these complex relationships, economists like to look at the trade-weighted or "effective exchange rate." This tells you what is happening to the yuan on average against all China’s trading partners (with each weighted for its importance in China’s trade). In 1994 China started to peg its currency to the U.S. dollar at a rate of 8.3 yuan per dollar. But it’s interesting that the effect of this choice of "stability" for the currency was to bring about gradual and sustained appreciation of China’s effective exchange rate from then until about 2002 (click here to see Chart 1 ). Over that period on average the U.S. dollar was appreciating against China’s other trade partners and China followed the dollar up.
This turned out to be a good exchange rate strategy for China. You can see in Chart 2 that from 1994-2002, China had a modest current account surplus that did not change very much. As a developing country with rapid productivity growth, China’s external accounts were kept roughly in balance by the gradual appreciation resulting from the link to the dollar.
While it was nice to have this kick to growth, this surplus was not in China’s interest. As a developing country with a high rate of return to investment, it does not make sense for China to export capital on this scale. The effect of the large surplus was to put a lot of liquidity into the system that then fueled booms in the stock market and real estate. Also, the export sector expanded too much, and now is almost certainly faced with serious over-capacity.
In retrospect, China stuck with its peg to the dollar for too long. It started to appreciate against the dollar in 2005 and since then has appreciated a cumulative 18 percent. With the recent global financial crisis, the U.S. dollar has appreciated – somewhat ironically, since the crisis originated in the U.S. – against other currencies. You can see in Chart 1 that the effective appreciation of the yuan in the past half year has been extremely sharp. The cumulative effective appreciation since 2005 is about 30 percent.
There is a lot of potential for misunderstanding in this area. China feels that it has had a rapid effective appreciation and now wants to see what the real effects are before going further. The U.S. is probably looking at a substantial devaluation of the dollar against other major currencies, as the immediate financial crisis wanes and the U.S. needs to rein in its consumption and save more. If that happens, it is not in China’s interest to follow the dollar down. It will take good coordination between China and the U.S. to resolve their large imbalances in a smooth manner.