For weeks now, the US government has been accusing China of manipulating the Yuan so as to make Chinese exporters' products more competitive in the marketplace. Of course, China does indeed peg the Yuan to the dollar; it is a "soft" peg, yet a peg nonetheless. While it does indeed make Chinese exports cheaper for Americans, keeping the Yuan undervalued also has the detrimental effect of reducing the purchasing power of Chinese citizens, as the Chinese central bank prints the Yuan out of thin air to buy US dollars.
Unfortunately for the Obama Administration, the Chinese are not going to fold on this issue, and a look at some salient facts will tell us why.
1. About 35% of China's GDP comes from exports. If the Yuan were to rise dramatically, a huge percentage of China's economy would take a hit. Yes, input prices would fall in terms of Yuan and Chinese consumers would be able to buy products more cheaply, but the hit taken by export companies would lead to sharp job losses. In a nation where social stability is of the utmost importance to the government, big job losses are unacceptable. The percentage of GDP from export has to fall before China will allow the Yuan to freely float, and the Chinese government is trying to create more domestic consumption with coupons, rebates, and other gimmicks. The point is that I do not foresee the Yuan freely floating for at least another decade.
2. The Chinese government cannot be seen as losing face. The concept of "face" in Asian countries is very difficult to put into adequate words for those of us in America, where we, in general, are outward directed. I think that Huang Shuanfan's 1987 definition is the best I've seen: Face is a sense of worth that comes from knowing one's status and reflects concern with the congruency between one's performance or appearance and one's real worth. If the Chinese government is seen as doing what the American government wants it to do, then its status in the eyes of its people is lessened. In a sense, China's appearance of weakness vis-a-vis the US would reflect -- in the minds of its leaders and people -- true weakness. The Chinese government doesn't want its people thinking that it is "wobbly," and it certainly doesn't want generals in the People's Liberation Army to think so. Ironically, calling the Chinese out in public was probably the worst thing that President Obama could've done if he wanted some Yuan appreciation, since it drew attention to the issue and made compliance more "expensive" in terms of face for the Chinese government.
3. The Chinese government has essentially told its citizens to continue to expect inflation. Since September 2009, the Chinese government essentially warned its citizens to prepare for inflation for the foreseeable future; it told them to purchase gold and silver. Indeed, government-run television is advertising gold and silver ownership. This in a country that for decades banned the holding of such bullion. If the Yuan was going to appreciate, there would be no need for the citizens to hold metals; holding metals would be a losing proposition. Again, the government will not want to lose face; I doubt it will let metals collapse in terms of Yuan.
Disclosure: Author long physical gold and gold miners.