In a move that caught many people by surprise, China announced on Thursday, July 21, 2005, it was immediately dropping the value of the Chinese currency, the yuan by 2.05% to 8.11 from 8.28, the previous rate. They also announced the decoupling of the value of the yuan to the US dollar, shifting it to a “market basket” of numerous unspecified currencies. Let’s take a look at the impact of both of these moves and how it’ll affect trade.

A lowering of the value of the yuan has been expected for sometime now, but most observers were thinking it would be closer to the end of the year. But US and European political pressures probably spurred Beijing to move earlier than expected in the hopes of derailing legislative action that was loudly being debated by both of its major trading partners. Observers looking for a move later in the year were expecting a 5-7% adjustment downward and ardent Chinese critics will say that anything less than 10% was inadequate. So while the 2% devaluation is drawing complaints of “minimalism,” this is a cautious, carefully considered move on the part of the Chinese leadership.

One has to understand that while the Chinese economy has been growing at a pace of 9-10% for several years, the banking system is very fragile, because of huge, non-performing loans to government-owned companies throughout the economy that are inefficient and losing money to more productive and competitive foreign plants and joint ventures. But because of the size and number of these government-owned companies, Beijing can’t afford to “pull-the-plug” on them and dump hundreds of thousands of Chinese into unemployment. They have started a careful, but somewhat aggressive program of “reforming” these plants or converting them to private enterprises wherever possible. Therefore any precipitous move on currency valuation that could topple the banking system would be a disaster, not only for China, but the rest of the world. Just look at the effects of what was called the “Asian financial flu” back in 1999, when Thailand abruptly decoupled its currency from the US dollar, causing it to drop dramatically in value and dragging the rest of Asia, and then the world, into recession. The financial integration of the world’s economies is even greater today than it was then, so China has to tread lightly, with carefully considered moves, but at least it’s a move in the right direction and demonstrates a willingness to cooperate.

The pegging of the yuan to a “market basket” of currencies is not as surprising, since China announced just in the last few months that it was headed in this direction. But don’t expect any wild fluctuations, because the Chinese themselves said on Thursday, they would keep the yuan in a very “tight band” or range within the basket of currencies. In other words, manipulating the value within the basket will continue, just as they did in maintaining the yuan’s low value against the dollar. That means buying and selling foreign currencies and financial instruments, as the yuan needs to be maintained within this tight range of values. China bought huge amounts of US Treasuries over recent years in order to keep the yuan undervalued against the US dollar. While the dollar is undoubtedly in the basket of currencies, this does mean that a lot of those purchases of foreign financial instruments that were flowing into the US will now be spread around to other countries. US Treasuries will undoubtedly slip in value, forcing a higher interest rate to attract buyers and driving up equities in the short-term as a place to invest. An unintended, but beneficial result of this move is that China is improving the flow of capital in markets around the world. In the long run, this could help spur the European economy into recovery.

Another side effect will be to motivate other Asian countries to decouple their currencies from other national currencies. Malaysia announced the next day that it would no longer peg it’s currency, the ringgit, to the US dollar. Others can be expected to follow.

So what’s the expected impact on trade? Ever so slightly higher prices on Chinese-made goods coming into the US and ever so slightly lower prices for US made goods sold in China. That should help the trade deficit between the two countries, but not by much, and may be not at all. Remember, a 2% increase in the cost of imported goods probably won’t effect consumption much and trade is measured in dollars, so the value of imports will actually go up, possibly making the deficit look worse for a while. If the lower value of exports increases our sales into China, then the deficit will start to narrow, but that will take a while to develop.

The lower value of the yuan will actually help the Chinese since most commodities (oil, gas, concrete, steel, copper, etc.) are quoted in US dollars, making the cost of those imports into China cheaper. And China is not only in the midst of massive industrial growth, but also infrastructure growth, plowing billions of yuan into roads, bridges, dams and power plants. Those are prime businesses for US expertise and export opportunities.

And there’s another, quiet, often unspoken side to all of this. China has a growing affluent middle class that now measures in the 100 million or more. Cheaper imports of designer and upper-end goods will meet a welcoming, growing consumer base that grows every year. That’s why Wal-Mart has aggressive expansion plans in China with the opening of 15 stores this year alone, including its first super-centers in Beijing and Shanghai. While some observers predict a “loss” in the situation for Wal-Mart here in the US because of higher prices, from a corporate standpoint, this should be more than offset with growth internationally, which is where Wal-Mart has been predicting its major future growth was going to come from anyway.

As things settle down and the Chinese economy adjusts to this change, don’t be surprised to see additional small, incremental adjustments in the value of the yuan in the months ahead. If this week’s moves work without jeopardizing the stability of the Chinese economy, they’ll be more willing to make future adjustments. Just don’t expect sharp swings or major moves in any direction. This is going to be a slow, calculated process.