The value of the Chinese yuan (also known as the renminbi) relative to the U.S. dollar has become a favorite target for U.S. politicians who seek to blame someone outside the U.S. for changes in trade flows. While relative currency rates are an important policy issue, the coming banking system changes in China are more far reaching that just exchange rates and will have a greater impact.

Under commitments made when joining the WTO, China must fully open its banking system to foreign competition in 2007. According to a recent article in the Wall Street Journal, Chinese financial institutions are spending hundreds of millions of dollars to upgrade their computer systems and to train thousands of bankers and bureaucrats in international financial practices. Companies like IBM of the U.S. and SAP of Germany are supplying hardware, software and expertise to run modern banking systems. The International Monetary Fund, the Federal Reserve Bank of New York and other economic policy groups are hosting courses in monetary policy for Chinese government officials and bank leaders. Some Chinese banks are hiring foreign banking experts to be part of their staff.

The Peoples Bank of China, the central bank, has over 100,000 employees, five times as many as the U.S. Federal Reserve. These are scattered in nine districts and 1,800 sub-branches across the country. The China Banking Regulatory Commission employs another 20,000 workers.

Supporters and detractors of the current Chinese monetary policy of a fixed exchange rate of 8.28 yuan to the dollar agree that modernization of the Chinese banking system is long overdue. By some estimates, roughly half of the bank debt would be considered bad debt based on regulations used in the developed world. The lack of computer systems allows businesses in debt trouble to receive new loans from other banks that lack information to make sound decisions. Other frauds and corruption are common.

These changes in the banking system will be good for the Chinese economy and will make adopting a flexible exchange rate easier to accomplish with as little disruption as possible. Despite claims by U.S. politicians, studies show that increasing the value of the yaun relative to the dollar is not a magic elixir for the U.S. economy.

A study titled Coping with Global Imbalances and Asian Currencies from the Asian Development Bank released in May analyzed the impacts of a one-time 10 percent increase and a one-time 20 percent increase of the yuan relative to the dollar beginning in the second half of 2005. Under both scenarios the growth of the Chinese economy would slow, inflation would slow and real interest rates would increase which would slow capital investment.

The 10 percent increase in the value of the yuan would result in a 1.9 percent decrease in the growth of the Chinese economy, an over 20 percent reduction from the expected rate. A 20 percent increase in the value of the yuan would reduce economic growth by 3.9 percent, reducing economic growth by almost 50 percent. The report notes that the 10 percent increase in the value of the yuan could help to control an overheating Chinese economy while the 20 percent increase could risk a hard landing.

The 10 percent increase in the value of the yuan would improve the U.S. trade deficit by only $3.6 billion. The total U.S. trade deficit was $666 billion in 2004 and the U.S. trade deficit with China was $165 billion. The 20 percent increase in the value of the yuan would improve the U.S. trade deficit by $7.9 billion.

These relatively small impacts are caused by two factors. First, imports from China account for only 13.4 percent of total U.S. imports and exports to China account for only 4.3 percent of U.S. total exports. Second, imports would increase from the rest of Asia because their monetary policies were assumed to be unchanged.

Some revaluation of the yuan would likely be good for the Chinese economy, but it could easily be overdone. Given the countrys underdeveloped banking system and lack of experience in managing monetary policy, navigating a so called soft landing for the Chinese economy through currency revaluation is an unlikely prospect over the next year or two.

The sensitivity of the Chinese economy to a 20 percent increase in the value of the yuan compared to the U.S. dollar shows how unwise it is to have politicians from other countries making suggestions about monetary policy for a country. The U.S. has an independent Federal Reserve Board for setting monetary policy to keep control of monetary policy separate from the short-term political thinking of Senators and Representatives. Just as policy makers in the U.S. ignore the advice offered by politicians from other countries, there should be little surprise when Chinese officials do the same.

In a world of floating exchange rates it is increasingly difficult for a major economy to have a fixed exchange rate with another major economy. The Asian Development Bank study notes the resulting problems of inflation, excess capital inflows and management of monetary reserves. Those are problems that China must address in the months ahead.

The best policy for China and the rest of the world is for the Chinese banking system to continue to work on modernization to prepare for banking reforms beginning in 2007. At the same time monetary authorities at the Peoples Bank of China must continue to develop a better understanding of monetary policy and create a policy that is transparent for domestic companies, outside investors, trading partners and monetary authorities in other countries.