How a Rising Chinese Yuan Complicates Life for U.S. Companies

Days before a key meeting of the world's 20 largest economies -- the G-20 Summit on June 26-27 in Toronto -- China has signaled a shift in currency policy. It will allow its currency, the yuan or renminbi, to float instead of pegging it to the U.S. dollar.

For the time being, China's move is meant to show good faith toward the G-20. But if it goes beyond a political gesture to a lasting economic policy shift, it will represent a huge change that will affect America in big ways.

According to The New York Times, the renminbi had advanced 0.42% to 6.7976 per dollar when currency markets closed on Monday in Asia. This tiny one-day gain is the largest in five years. According to the Times, "China has hardly allowed the currency to budge over the past two years as it tried to promote its exports during the global economic and financial crisis."

Changing the U.S.-China Dynamic

It's hard to know whether a strengthening yuan will help or hurt America. But there's no question that it represents a considered response to pleading by Western finance officials over the last decade. The reason for Western demands to let China's currency rise to reflect its economic strength was pretty simple: Manufacturers in the West are losing market share to China's super-cheap labor costs.

But at least China's policy was consistent, and as a result, U.S. business responded to those low costs by moving manufacturing to China. And U.S. consumers bought those cheaply made goods while the U.S. government piled on debt that it financed, thanks to China recycling its foreign exchange profits into U.S. Treasury bonds.

But a rising yuan changes all this. For the time being, U.S. companies may be in a holding pattern waiting to see whether China is serious about letting its currency rise. According to the Times, however, such increases are likely to remain modest -- between 2% and 5% by the end of 2010.

More Luxury Goods and Pizza Sales

If the Chinese currency continues to appreciate, though, the economic effects could be significant. First and foremost, a rising yuan gives Chinese consumers more purchasing power. Rising purchasing power in the hands of ordinary Chinese citizens means more business for consumer-product companies that sell in China.

The winners could include Swiss watchmaker Swatch and French luxury-goods groups LVMH and Richemont, whose shares enjoyed hefty increases on Monday. Yum Brands (YUM), which owns the KFC and Pizza Hut fast-food chains and gets about 33% of its profits from its 3,500 locations in China, would also benefit from a stronger Chinese consumer spending.

But a rising yuan also means that U.S. manufacturers may be forced to switch their strategies in two major ways. First, they may look to other, lower-wage countries than China, such as Vietnam, in which to manufacture their products. During this transition period, the price of Chinese goods bought in the U.S. would rise -- causing inflation to spike. And second, those U.S. manufacturers may seek to sell more of their output to Chinese consumers.

A Delicate Balance

Before U.S. companies actually make such dramatic changes, they ought to consider one thing very carefully: China will sustain a rising yuan policy only if it serves its domestic political interests. In so doing, China will seek to balance the needs of its manufacturers, which benefit from a weak yuan, against those of its workers and consumers, who would be better off with a strong yuan.

Recent strikes by Chinese workers suggest that China's government might be afraid that a weak yuan is creating so much political instability that the biggest political risk it faces is an unhappy Chinese worker. If so, China will sustain a rising yuan, which will force U.S. manufacturers to shift their strategies.

Ultimately, this shift might make China keep more of its money at home rather than using it to buy U.S. Treasurys. How so? As China sells less to U.S. consumers, it won't be as willing or able to keep buying massive amounts of U.S. debt.

And that, coupled with the Fed's desire to clip the wings of inflation created by the higher price of Chinese goods, could lead to higher U.S. interest rates. Given how much debt the U.S. owes, those higher rates could put a crimp in the current economic recovery.