As I reported last month, a high ranking government official in China recently floated the idea of a free trade agreement with the U.S. So far there’s been no response from our side.

Now the Chinese just announced that they will expand the Yuan’s trading band to 1% from its previous setting of .5%. This means that the Yuan can now fluctuate up to 1% against the U.S. dollar in any one day of trading.

U.S. Treasury Secretary Timothy Geithner called this move “very significant and very promising.” The U.S. government is hoping the Yuan will come to a point where it will trade freely on the open market, driving up the value of the Yuan and making U.S. goods more competitive. 

I’ve heard it said that “be careful what you wish for; you may get it.” There’s more going on here than just the exchange rate of the Yuan vs. the dollar, some of which miffs me that the media or our government doesn’t talk about much.

According to the Wall Street Journal, in 2010 85% of foreign exchange transactions world-wide were trades of other currencies for the dollar. OPEC sets the price of oil in dollars. 60% of the foreign reserves of central banks and governments are in dollars. If an importer from South Korea, for example, wanted to import a product from Argentina, they make the transaction in dollars.

After the economic dump of 2008, China started altering the landscape.  

Since then, China has made currency swap agreements with 17 countries, including Japan, Australia, South Korea, New Zealand, & Singapore. The U.K. is rumored to be next. Part of what these swap agreements entail is the ability to settle trade in a currency other than the U.S. dollar, i.e. the Chinese Yuan. This means that the dollar is now facing competition in how world trade is conducted.

Why are the Chinese doing this? Is it because they want to dominate the world and take everything over?

The Wall Street Journal pointed to the fact that our “trillion dollar deficits stretch as far as the eye can see,” and that as we grow deeper in debt, more countries will question whether we’ll resort to the printing press. China, the world’s largest holder of dollars, is getting nervous that we’ve lost the will to balance our budget and will devalue the dollar, taking the worth of their assets with it. The more China can trade in Yuan, the less their risk of loss.

In other words, we’re to blame for the changes that will soon face the dollar.

There might come a day where the U.S. has to import and export some of its product like the rest of the world does, by incurring the expense to exchange its currency for another. When I travel to China or Europe, for example, I have to change my dollars into Euros or Yuan at a cost from a bank in order to purchase local goods and services. It’s the same thing just on a larger scale.

The Wall Street Journal drew a picture of a world where trade is conducted in dollars, yuan and euros. In such a place, we would no longer have the luxury of printing and borrowing at will as this would make trade in dollars even less attractive than before—and spike inflation. Think Argentina in the early 2000s or Russia in the early 90s. If the Yuan was free floating and the Chinese wanted a transaction done in Yuan instead of dollars, and the dollar dropped in value between the time the order was placed and when it was shipped, the U.S. customer would take the loss. Today, it works in the reverse where the Chinese take the loss when they take orders in dollars and the Yuan appreciates.  

The best course of action would be for the U.S. government to get its act together and balance the budget, but it doesn’t seem like that’s going to happen. Unfortunately, this means the scenario above will one day be reality.

Wall Street Journal: Foreign Exchange report
Swiss Metal Assets

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The Exchange Rate
Yuan to the dollar, as of today: 6.31 to 1
Rate when the Yuan was depegged from the dollar onJune 19, 2010:  6.82 to 1
Change: .51 (7.4%)

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