Ok.So China has announced its intention to remove the Yuan Peg on the US Dollar. The world has jumped with joy on a positive sentiment. But is the bumpy ride really over? Is it really going to be as smooth as we think it is?
Let us begin by what pegging is actually all about. You see, currency rates all over the world are determined by demand and supply forces. Assume that a particular country is export oriented, and that its exports, and therefore the economy are doing good. This means the companies there are doing well. This means foreign investors are interested in buying stocks of those companies. They will want to set up partnerships, open up branches, sales offices etc. All this means that they will require the currency of that country in order to buy stocks and goods, or do all these activities.This means, eventually, that because the economy is doing well, the demand for currency of a country will rise.
This is where the game begins. Because the demand for the currency increases, the value of the currency appreciates.This means that the same goods now become more expensive. This means that its imports increase and exports decrease, because other countries goods become comparitively cheaper. Simply put, the economy of the country no longer does well. This means that the demand for the same currency now reduces. This means that the currency now depreciates.We are back to the same situation!
Do you see the self correcting cycle here? This, as we all know, is text book economics. In the long run, whichever country or economy manages to hold on to the positive cycle does well. But the point is that it is this cycle, or fluctuations, as we call, that is responsible for what we know as ECONOMIC EQUILIBRIUM.
Now what pegging does, is that it isolates the currency from this self correcting cycle. China, as we know is an export oriented country, and the world over uses products manufactured in China. As we now, its all "Made in China". Pegging means that your currency is RELATED or STUCK with another currency (base currency), and the movement of your currency is determined, not by the international trade cycle described above, but by the movement of the base currency. China had so far pegged its currency to the US Dollar. So, the strength and movement of the Chinese Yuan was determind directly by that of the US Dollar. Essentially,the Chinese currency is devaluated, or depreciated in value. Thus, its products always are much less expensive than most others, and this has been a major reason why China has dominated the world product export markets in the last 3 decades.
With pegging removed, the Chinese Yuan becomes dependent on the international trade cycle for value determination. This means that it no longer would enjoy the advantage of a constant perrenial devalued currency. It therefore falls int the 2nd part of the above cycle. A move to UN peg the currency means the currency will appreciate in value, thus resulting in lower exports etc etc. More importantly, this opens up the world export markets by reducing China's domination. The USA will be most happy with this development because this gives them an opportunity to reduce their trade deficit- the difference between exports and imports. In the case of the USA, this is highly negative, given its exeptionally strong consumption pattern.
This explains why the market sentiment was strongly positive on the first day itself. However, the immediate slow down on the 2nd day and subsequent expectations seem to imply that such a huge change cant happen so soon and smoothly. World economies still need to control costs and increase efficiences to match the bandwidth and expertise built up by China in 3 decades. If the Chinese currency starts appreciating too much, it could again buy US dollars, thus increasing the value of US dollar, and subsequently devaluating its own currency Yuan.
This is quite early to predict how this event unfolds in the coming time. However, world economies must be a little careful in being too cautious or aware of this, because improvement is needed all across. My first prediction is that if the un-pegging indeed takes place, it is going to be a good development globally.