China's repegging to the dollar is critically important to global trade. It gives China a free lunch: not only are China's exports protected by the US dollar's decline, they will increase as the yuan declines relative to other currencies.
Harvard economist Jeffrey Frankel uses regression analysis to determine China's yuan policy. His research shows that in 2005, Beijing de-pegged from the dollar and re-pegged to a basket of the dollar and the euro. According to Frankel, the 20% appreciation of the RMB from 2005 to 2008 was a reflection of the euro's rise against the dollar. Recently, the Chinese have moved back to a dollar peg. Frankel said that "during the most recent period, September 2008-February 2009, all the weight has once again fallen on the US currency. The regime has come full circle, virtually back to what it was in late 2005."
The dollar peg is not a completely free lunch, as it has been a cause of inflation in the past. But, the dollar peg is a good hedge for the Chinese against continued dollar weakness (which devalues its reserves). It is terrible news, however, for exporters such as the EU and China's Asian neighbors. We have already seen Asian exporters--Malaysia, Hong Kong, Singapore, Korea--intervene in currency markets to prop up the dollar. As for the EU, any backlash will be more political than monetary. This might be an opportunity for European politicians to take up Senators Graham and Schumer's fight for a stronger yuan.
China's new dollar peg also puts comments by Premier Wen Jiabao and PBC Governor Zhou Xiaochuan for a new global reserve currency in a different perspective. These comments were made when the dollar was enjoying its strength as a safe haven. Now that the dollar is falling again (and China is reaping the benefits), I would expect comments like these to be much less frequent. For all its talk of rebalancing global trade and currencies, China's actions echo the infamous words of St. Augustine: "give me chastity, just not yet."
