China's Managed Floating Exchange Rate - Still Pegged to the Dollar
 In 2005, China lifted their long-standing peg of the yuan against the dollar and moved to a managed floating exchange rate within a narrow window (±0.3%, expanded to ±0.5% in 2007). The window moves based on a basket of foreign currencies, dominated by the dollar, euro, yen, and won. While China does not disclose the weightings in this basket of currencies, it can be reverse engineered using statistical algorithms that have been developed. From 2005 to mid-2008, the yuan was based primarily on the euro and dollar, and since the euro rose against the dollar during that period, so did the yuan (see Figure 1 - the red line is the price of gold in dollars, blue line is the price of gold in yuan).
Figure 1 - Yuan Rises Against the Dollar 2005 to 2008
China shifts the currency weightings as it pleases, to suit its policy objectives. In fact, since mid-2008, the basket became almost entirely dominated by the dollar, in effect re-pegging the yuan to the dollar (see Figure 2 - price of gold vs. dollar and yuan moving in near perfect unison). At the time, there was much speculation about China's motives for that move, since the dollar was rising and it seemed counter to China's interest, because it made their exports more expensive in most currencies. Some have theorized that it was done to ease trade tensions with the U.S. during the severe recession.
Figure 2 - Yuan Effectively Pegged to the Dollar from July 08 to Present (Last 12 Months Shown Above)
Appreciation of the Yuan is Expected... But When?
International pressure has been mounting on China to allow the yuan to appreciate. On March 6th, Zhou Xiaochuan, the Governor of the People's Bank of China, said that China will change its current exchange rate policies, which he said was a temporary response to the global financial crisis. Some analysts have been predicting for a while that there would be a revaluation of the yuan, but this was the first time a top official from China said that the de facto peg to the dollar will end in the near future. However, Zhou warned that the change won't be that soon, and few are predicting a sudden, dramatic move.
U.S. - China Friction on Exchange Rates
As if to emphasis the uncertainty on this point, last Friday (March 12th, 2010), People's Bank of China Vice Governor Su Ning made some pretty direct statements in response to the ongoing, highly visible (from President Obama on down) nagging from the U.S. to let the yuan rise. China has said in effect, "don't blame your trade imbalance on us". While it is not clear that a rise in the yuan will do much to impact the balance in trade - the issues are more fundamental than that - the pegged exchange rate is a convenient whipping boy for US politicians.
Who Cares What Happens to the Yuan?
Many people besides currency traders have an interest in what happens to the yuan. This includes not only policy-makers responsible for trying to improve foreign trade deficits, but also sourcing personnel in the many companies that source materials and goods from China. Because the Chinese domestic market is growing rapidly, more and more companies are importing into China. Importers into China may have an even greater interest in hedging against a rise in the yuan, since their products will become less competitive if the yuan appreciates. Companies that import about the same amount (value) as they export from China have less to worry about, as they have the luxury of a natural hedge (if they are sophisticated enough to deal with it across different P&L business units).
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