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Over the past year, wild speculation and furious debate have turned the future of the Chinese currency, the yuan, into the hottest and most polarizing topic in the global economy. Pegged to the U.S. dollar since 1994—meaning that when the value of the greenback rose or fell, so did the yuan's—China's currency had come to embody the industrialized world's fears of a hypercompetitive mainland staging a hostile takeover of global manufacturing. Led by the U.S., critics accused China of clinging to the dollar peg in order to keep the yuan artificially weak, making its exports extra cheap and fostering a worrisome trade gap with the U.S. that ballooned to a record $162 billion in 2004. Unless Beijing changed its currency policy, a trade war loomed. Still, Beijing wouldn't budge, leaving businessmen and investors across the globe guessing as to when this uneasy status quo might finally change—and how dramatically.

Although considerably more muted than expected, the answer came on July 21, when the People's Bank of China posted a notice on its website announcing the end of the yuan's peg to the dollar. Citing its wish to "improve the socialist market economic system in China," the bank set the yuan at 8.11 to the dollar—a 2.1% increase in its value—and decreed that henceforth it would trade within a narrow band of 0.3% each day against a basket of (unnamed) currencies. Now that the yuan is allowed to float, even only slightly, its value should better reflect China's buoyant economic growth and its booming trade with the rest of the world. But the 2.1% shift is so slight that it amounts to little more than "a toe in the water," says David O'Rear, chief economist at the Hong Kong General Chamber of Commerce.

Indeed, financial markets greeted the change without a fuss. But much like the famous butterfly of chaos theory, which flaps its wings in Brazil and sets off a tornado in Texas, Beijing's decision portends momentous consequences for the global economy down the road. Scrapping the dollar peg is widely seen by economists as the first step toward a free-floating, and much stronger, yuan. If the yuan continues to appreciate, China's new currency policy could reorder global trade and investment, boost the power of Asian consumers, and address global trade imbalances. U.S. Treasury Secretary John Snow, who had been a vocal critic of Beijing's peg, said "full implementation" of the new policy "will be a significant contribution toward global financial stability."

Snow was not the only one to applaud. China's move received qualified praise from Bangkok to Tokyo to Washington, where U.S. Federal Reserve Chairman Alan Greenspan called it "a good first step." It's unclear whether Beijing acted because of American pressure or in spite of it. Zhou Xiaochuan, head of China's central bank, said the shift was made because the dollar had become too volatile, so it was in China's own long-term interest to change. Whatever the reasons, the decision is expected to smooth strained relations between China and the U.S.—good timing, given that a meeting in Washington between Chinese President Hu Jintao and U.S. President George W. Bush is scheduled for September.

Temporarily, at least, the announcement should also placate hawkish politicians in the U.S. and Europe who were lobbying for protectionist measures to stem the tide of Chinese imports. Legislation in the U.S. that would have imposed a 27.5% tariff on all Chinese imports if Beijing didn't revalue—a measure that received an unexpected level of support in the Senate earlier this year—now appears to be going nowhere. Also easing anti-Chinese sentiment in the U.S. were setbacks last week to two attempted acquisitions of U.S. firms by Chinese companies. Mainland appliance maker Haier dropped its $1.28 billion offer for Maytag, and a politically controversial $18.5 billion bid by China National Offshore Oil Corp. to buy U.S. oil giant Unocal has run into stiff headwinds after Unocal's board voted to stick with an improved offer from American company Chevron. Revaluing the yuan "buys the Chinese significant political capital," says Hong Kong-based Merrill Lynch strategist Spencer White.

But at what price to the Chinese economy? China had resisted ending the peg partly out of fear that its factories would become less competitive, which would cost the country jobs and curtail growth in its export-fueled economy. Officials for Chinese companies that compete almost entirely on price, such as those in the toys and textiles industries, say even this 2.1% increase in the yuan's value will hurt sales to cost-conscious U.S. retailing giants such as Wal-Mart and Target. Yu Zhihua, export manager for the Hangzhou Silk and Garment Import Export Corp. in Hangzhou, says her profit margins are so thin already that she can't afford to lower prices to offset the 2.1% difference in currency values. "We expect contracts that would have gone to us will switch to Bangladesh and Indonesia," Yu says.

Indeed, Deutsche Bank estimates that a 5% appreciation of the yuan would slice 5-10% off the profits of China-based textile and electronics exporters, because they have narrow margins and little power to adjust their prices. The pinch will also be felt by the many foreign companies operating mainland factories. Tony Cheng, a Taiwan businessman who runs a factory in Shenzhen making Christmas ornaments, calls the revaluation "a big blow."

But one company's pain is another's pleasure. The net effect on some sectors will be positive. China's automakers, for example, rely heavily on parts made abroad and export few cars. The stronger yuan will effectively lower their costs by reducing their outlay for tires and other imported components. Meanwhile, firms that have been hurt by the rising price of oil, such as airlines, will also get relief: oil is priced in dollars, so companies earning in yuan will see their energy costs decline by 2.1%. In fact, China's macroeconomic landscape is expected to remain virtually unchanged by this initial revaluation. Overall growth, which reached a scorching 9.5% in the second quarter, is expected to remain extremely robust. "Simply put, we don't see any effect whatsoever of a 2% revaluation on exports or imports," wrote Jonathan Anderson, an economist at UBS in Hong Kong.

In the short run, at least, China's revaluation of the yuan should give the rest of Asia a little breathing space. In order for their industries to remain competitive with China's, central bankers throughout the region have been trying to keep their currencies from appreciating against the dollar—an increasingly difficult challenge as their economies strengthened. Yuan reform could remove the first log from the logjam—the Japanese yen, Korean won and Thai baht all rose against the greenback immediately after China revalued. And within an hour of Beijing's announcement, Malaysia ended its 7-year-old peg of the ringgit to the dollar, which was imposed during Asia's financial crisis to help stabilize the faltering economy. Malaysia had to move almost immediately after Beijing acted, or else the speculative pressure from punters betting on a rising ringgit "would have been immense," says Manu Baskaran, a partner with the Singapore office of consulting firm Centennial Partners. "It was an excellent opportunity to make a change that really should have been done sometime ago," he adds. "You can't stay pegged forever."

Economists hope that China's modest revaluation will ripple gently through Asia and the rest of the world. By giving scope for Asian currencies to strengthen, economists expect that the yuan's rise will effectively boost consumer-spending power throughout the region, because imports will become cheaper and interest rates will tend to remain low. In this way, the reform of the yuan could usher in a major shift in the way the global economy works: the knock against Asia is that it saves too much and spends too little, while the U.S. spends too much and saves too little—leading to huge U.S. deficits that some economists fear could destabilize the world economy. If Asians begin to spend more, export-led economies everywhere will be less dependent upon U.S. spending for growth, reducing the risk of a recession should American consumers falter. The 2.1% rise in the yuan "is a baby step, but it is the start of a very important process," says Frank Gong, chief China economist for JPMorgan. Over the long term, he adds, China's yuan reform could bring about "more balanced global growth."

Still, this initial yuan adjustment will do very little in itself to address China's yawning trade gap. Merrill Lynch predicts that China's trade surplus could exceed $90 billion this year—nearly three times larger than in 2004. U.S. critics of China will likely keep agitating for a full float of the yuan–mean-ing that it would trade at whatever exchange rate the market determines. "We expect more," said U.S. Senator Charles Schumer, one of the sponsors of the bill that would impose a punitively high tariff on Chinese imports.

Economists predict that the Chinese government will gradually allow the yuan to appreciate—Deutsche Bank expects a 10% gain against the U.S. dollar over the next two years. And as the Chinese currency strengthens, the economic consequences become harder to foresee and control. Hot money could pour into China from speculators looking to profit from additional yuan gains, undoing Beijing's efforts to curtail excessive spending and lending in overheating sectors of the economy such as real estate. Also, if the yuan goes up by 10%, "you start to worry about China's competitiveness," says William Fung, managing director of Li & Fung, a Hong Kong trading group that arranges for overseas buyers to manufacture products in Chinese factories. Companies from India to Mexico, which in recent years have struggled to compete with China's low costs and high efficiency, could start to claim new business, says Fung. Merrill Lynch estimates that a 10% increase in the value of the yuan would shave 1.8 percentage points off China's GDP growth rate. Meanwhile, foreign investment in the Chinese economy could start to flag, says Takahide Kiuchi, a senior economist at Nomura Securities in Tokyo.

Some ordinary Chinese think the government has already gone too far by allowing the yuan to increase by 2.1%. In the days following the revaluation, China's websites hummed with nationalistic criticism of Beijing for knuckling under to American pressure. "How very obedient we are!" read one typical posting on a popular bulletin board run by the People's Daily newspaper. "China will become a puppet colony that breathes the air exhaled by Western countries," read another. Beijing may have taken an important first step toward a more fair and open currency regime. But amid a world of countervailing economic interests, China must now take another step, and another, while trying not to stumble.

• Michael Schuman | Hong Kong
• China finally revalues its currency, to the relief of a world worried about record trade imbalances. But is 2.1% really enough?