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What If China Revalues?

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It would improve US trade competitiveness, stimulate economic activity, boost employment, and eliminate a major source of total US indebtedness.

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On March 6, 2010, Chinese Central Bank Governor Zhou Xiaochuan acknowledged that "sooner or later" the peg of the Chinese Renminbi Yuan (CNY) to the US Dollar must end. This statement, together with various economic considerations, has prompted widespread expectations that Chinese authorities may soon allow the CNY to revalue relative to the US Dollar.

Some fear mongering pundits have been warning that this could trigger a US Dollar collapse and an inflationary spiral. More generally, I think that the potential consequences of a revaluation of the CNY are ignored.

In this article we shall explore what a revaluation of the Chinese CNY would mean for the US Dollar and for the US economy generally.

How Would the Value of the Dollar Be Affected?

The value of the US Dollar is usually measured in terms of its relationship to a basket of currencies that comprise the US Dollar Index (USDX). Currently, the composition of the USDX is as follows: Euro (EUR) 57.6%,Yen (JPY) 13.6%, British Pound (GBP) 11.9%, Canadian Dollar (CAD) 9.1%, Swedish Kronas (SEK) 4.2%, Swiss Francs (CHF) 3.6%. PowerShares DB US Dollar Index Bullish (UUP) is an ETF that is based on the USDX.

Please note that the Chinese CNY isn't even part of the US Dollar Index. Therefore, if the question is how the value of the US Dollar -- as this term is generally used in the global financial community -- will be affected by the revaluation of the CNY, the short answer is: Not one iota.

Some might argue that the CNY should be included in the USDX. Precisely for this reason, the Federal Reserve created a trade-weighted index of the foreign exchange value of the US Dollar referred to as the "Broad Index." In this index the weight of the CNY is currently 17.33%.

On the other hand, it's also true that the CNY has for many years been pegged to the US Dollar. Since the CNY's value internationally has been wholly derivative of the value of the US Dollar, in this important sense the CNY hasn't been an independent currency at all. From this vantage point, it is understandable that the CNY has been disregarded when referencing the value of the US Dollar.

In any event, let us focus on the question of what will happen in the future to the value of the US Dollar relative to other world currencies if the CNY is revalued. The first thing that must be understood is that in such a scenario, the CNY will be automatically revalued relative to all the world's other currencies, not just the USD. Therefore, in principle, the value of the US Dollar will decline relative to the CNY, but its value won't decline relative to any other currencies, much less the currencies that comprise the US Dollar Index.

Quite the contrary, the trade deficit that the US has with China is one of the most important fundamental factors weighing against the value of the US currency. Given that a revaluation of the CNY would tend to reduce the US trade deficit with China, this should be a net positive for the US Dollar from a fundamental point of view.
No positions in stocks mentioned.
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