The United States wants China to allow the value of its currency to appreciate. This would make Chinese exports to the United States relatively more expensive, which would reduce the quantity demanded. It would also make U.S. exports to China less expensive, which should increase the quantity demanded and thus create more jobs in exporting sectors. If the reduction in the quantity demanded of Chinese exports and in the increase in the quantity demanded of U.S. exports is large enough, the current account deficit in the U.S. will narrow, the capital outflows from China will shrink, the global economy will be brought into greater balance, and the risk of a future financial crisis caused by the inflation of asset bubbles by the influx of foreign capital will be lessened.
China does not want this. China wants to keep its currency weak in order to keep the quantity of its exports demanded very high. This, in turn, boosts domestic employment in the exporting sectors. Given the still-very-large numbers of unemployed or underemployed Chinese with very poor standards of living, this is an understandable goal.
But one by-product of keeping the exchange rate low in the face of a trade imbalance is that it puts upward-pressure on domestic prices. Krugman explains:
Consider the real exchange rate, defined as RX = EP*/P, where E is the exchange rate measured as the domestic currency price of foreign currency (so an appreciation of the renminbi is a fall in E), P* is the foreign price level, and P the domestic price level. Basic international macro says that there is a “natural” level of the real exchange rate, determined by trade competitiveness and international capital flows. And the economy “wants” to get to that real exchange rate.
If you have a floating exchange rate, you get there via a rise or fall in E. But if you have a pegged rate, there’s pressure on prices instead. By deliberately keeping E higher than it would be under floating, China is creating pressures for P to rise; the inflationary pressures are directly related to the exchange rate policy.
This is exactly right. Now that inflation in China may be well over 10%, Chinese officials are growing concerned. The savings rate in China is very high -- around 40% -- and many Chinese investors are hedging against inflation by buying tangible assets like housing. This may be leading to a property bubble in China. Moreover, high inflation hurts poorer Chinese (i.e. those who consume most of their income) by reducing their standard of living. Add to that the fact that China's currency is pegged to the dollar, so it has actually depreciated with the dollar relative to the yen and euro in the past year, and pressure is mounting for the Chinese leadership to adjust upwards the RMB's peg to the dollar.
What would be the effect of this? So long as China doesn't couple a currency appreciation with trade protection, it would increase the purchasing power of Chinese consumers and improve standards of living. Some employment in exporting sectors might be lost, but gains in employment in importing and nontraded sectors would offset some or all of that effect. Also, a stronger currency would likely attract more foreign direct investment, which could lead to domestic employment. If China also took steps to strengthen the social safety net it could reduce national savings rates, which would lead to more domestic consumption and thus more domestic employment. Moving towards currency convertibility could give China more influence in international financial markets, especially regionally.
This is the path that China will have to take eventually. The tradeoff between growing inflation + asset bubbles on the one hand and competitiveness in traded goods will only be resolved by either moving away from an open trading system or from an undervalued currency. China has been able to have it both ways for more than a decade now, but all good things (from their perspective) must come to an end.