Q&A: How China's Currency Policy Affects You Critics want China to revalue its currency. They say China's manipulation of the yuan hurts the U.S. economy. But others warn a revaluation could send interest rates for U.S. consumers soaring -- and might even cause a U.S. recession. Here, an explanation of the currency debate.

Q&A: How China's Currency Policy Affects You

Many in Congress want President Bush to pressure China's leader, Hu Jintao, to revalue the country's currency, called the renminbi or yuan. They say China's currency manipulation hurts the U.S. economy.

But others warn that a revaluation could raise interest rates for U.S. consumers -- and might even cause a U.S. recession. NPR's international business correspondent, Adam Davidson, explains the issues behind the currency debate.

What does it mean for a currency to be undervalued or manipulated?

Well, let's start with the U.S. dollar and the British pound. These currencies are freely traded on international markets. Their relative prices are changing all the time in response to news and business events. The dollar might go up against the pound because U.S. unemployment data showed the U.S. economy to be strong; then the dollar might go down a bit because Apple Computer bought several million dollars' worth of parts from Japan. China's currency doesn't work that way.

If not by the market, then how is the value of China's currency set?

China's central bank simply declares an exchange rate and forces, by law, all market players to observe that rate. The yuan is allowed to fluctuate a tiny bit, but not much -- and certainly not enough to accommodate the constantly changing pressures of the global marketplace. The Chinese have pegged the currency so that one U.S. dollar buys a little bit more than 8 yuan. Put the other way, one yuan is worth a bit more than 12 cents.

Most economists believe that if China's currency were allowed to trade freely, it would be worth more. No one can know for sure how much more, but leading economists put it in a range of 10 to 40 percent higher value than it is now. So, the yuan could go from being worth 12 cents to more than 17 cents.

Why should I care what the Chinese currency is worth?

By keeping the yuan artificially low in value, China is effectively giving U.S. consumers a discount on all Chinese exports. Why? Let's say a Chinese factory can make a profit selling DVD players for 800 yuan. That means they can then sell it to someone in the United States for $100. If the yuan were allowed to appreciate in value, that 800 yuan DVD player might suddenly cost, say, $115. If an American factory makes a similar player for $110, then that change in the value of the yuan can make the difference between business success and failure for the U.S. manufacturer.

So, by keeping its currency undervalued, China is discounting its own exports. That's good for U.S. consumers, who get to buy cheaper clothes and electronics and other items. But it's horrible for many U.S. manufacturers who find they can't compete with low Chinese prices. Some U.S. manufacturers, though, have adapted by buying many component parts at a lower cost from China. The ability of a manufacturer to adapt depends on the company and the product -- and even on the level of globalization in that industry.

What would happen if China does allow the yuan to appreciate?

Many domestic manufacturers argue that if China simply revalues its currency, U.S. factories would flourish, and U.S. workers would have more and better-paying jobs. Most observers, though, say that's unlikely. While some manufacturers in some sectors would certainly benefit tremendously from a Chinese revaluation, many others would see little benefit.

In reality, that 800 yuan DVD player would not suddenly go up to $115 if China revalued its currency by 15 percent. China's government would likely cut taxes to keep their manufacturers competitive. The manufacturers themselves could also absorb some of the cost increase.

And the revaluation wouldn't have an impact on other costs of Chinese-made goods, such as shipping and advertising. In short, that DVD player might still be cheaper than the U.S. model, even with a Chinese revaluation. It's important to remember that China's exchange rate is only one factor in a highly dynamic global economy.

Does it matter at all if China's currency is revalued?

It matters a lot, but more in the long term than in the short term. Except in a few special cases, few workers or factories will see a sudden change of fortune in the days, weeks and months after a revaluation. However, over the coming years and decades, a revaluation of China's yuan and an eventual move to a fully floating currency would make the global economy healthier and better able to adapt to changing economic circumstances.

I've heard that China's current money policy helps keep interest rates low for U.S. consumers. Why is that?

China's central bank needs to constantly buy U.S. Treasury bonds. It's for technical reasons: Basically, to keep its currency fixed against the U.S. dollar, China must promise to be able to redeem one U.S. dollar for every 8 yuan. As China's economy grows, it must buy more and more U.S. currency to meet the growing number of yuan.

Because China keeps buying U.S. Treasury bonds, the Treasury Department is able to keep long-term interest rates lower than they would be otherwise. (If China weren't such a big buyer, the U.S. Treasury might need to raise rates to attract other investors.) Since Treasury bonds are the benchmark for most long-term debt, those lower rates extend to credit cards and mortgages.

Those low mortgage rates have fueled a dramatic housing boom, raising the price of many homes. All those inflated home prices have injected countless billions of dollars into the U.S. economy. Americans are flush with home equity and cheap debt.

So does that mean that changing China's money policy could hurt the U.S. economy?

A revaluation could cause an economic slowdown, even a recession in the United States.

Now, if China revalues its currency abruptly, it won't have to buy so many Treasury bonds. As a result, mortgage and credit-card interest rates could jump upwards -- which means U.S. consumers would stop spending so much money. Stores and banks would be hurt. U.S. and Chinese factories wouldn't be able to sell their products, so they'd shut down or lay off workers. It could bring a self-reinforcing downward economic spiral.

Is it best to just do nothing?

In short, no. Most economists and policy makers in the United States and in China agree that, eventually, China must revalue its currency, or else global imbalances (America's $200 billion annual trade deficit with China) will grow too large.

There is a wide difference of opinion over how quickly China should revalue and what other measures need to happen to prevent painful economic costs. It is certainly theoretically possible to make the right adjustments in the right way so that both countries keep growing. It's also possible to do it completely wrong.