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What's Next for China's Currency?

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This article has been adapted from our sister site across the pond, Fool U.K.

The Chinese currency matters to all of us. As Owain Bennallack wrote last week, for example, a stronger yuan would buy more dollar-denominated commodities, boosting the fortunes of companies such as BHP Billiton (NYSE: BHP  ) and Rio Tinto (NYSE: RTP  ) .

In more macro terms, it would make it less attractive to import goods from China -- the country has long been criticized for keeping its currency artificially weak in order to boost its exports. And allowing the yuan to rise would allow the Chinese to buy more Western products.

For these reasons, President Obama was to the fore in urging China to allow its currency to find its true value on the market, rather than pegging it firmly to the dollar. The outcome, however may not be what the West expects.

What has China done?
Having pegged its currency at 6.83 to the dollar for the past two years, China has decided to revert to its former policy of pegging against a basket of foreign currencies, and has agreed to allow more flexibility in the exchange rate.

This move to a basket of currencies somewhat reduces the priority of the dollar in China's calculations, but more than 80% of its $2.4 trillion of foreign currency reserves are still denominated in dollars. That said, China currently does 30% more business with the EU than it does with the U.S. How this basket of currencies will be made up is not yet clear.

What direction for the yuan?
Given the historical direction of the yuan relative to the dollar, and the continuing trade imbalance between the two countries, it is generally accepted that the yuan will continue to strengthen.

Morgan Stanley expects to see it 10% higher by the end of next year, while Credit Suisse estimates that the Chinese currency is about 50% undervalued at present rates. Dominique Strauss-Kahn, managing director of the International Monetary Fund, does not expect any dramatic changes, but puts the yuan firmly in the "undervalued" camp.

But not everyone agrees. The benchmark exchange rate is relative to the dollar, but with the peg now based in part on other currencies, any weakening of the euro could cause the yuan to fall against the dollar, as Nouriel Roubini has argued.

Longer term, if China was to relax its exchange restrictions and allow the free movement of capital, it is far from certain that the net flow of funds would be toward China.

Yukon Huang, a senior associate at the Carnegie Endowment for International Peace and former country director for the World Bank in China, wrote in the Financial Times

Many [Chinese] have yet to consider that owning property abroad could be more attractive. But with greater flexibility in transferring funds, the Chinese will diversify their holdings more quickly by shifting capital abroad. ... [The yuan's] value in the next few years is anyone's guess.

More from Padraig O'Hannelly:

Brian Richards prepared this article for publication on Brian does not own shares of any companies mentioned. The Motley Fool has a disclosure policy.

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