China is essentially weighing a trade-off. A transition to a freer, more market-based financial system could pack many advantages, including a more efficient system of funneling savings into productive investment, more reliable savings vehicles available for its citizens, and advantages for Chinese companies as they do business across Asia and beyond.As Greg Mankiw explains, the international finance "trilemma" (or "impossible trinity" for those who think "trilemma" sounds too silly) implies that a country cannot simultaneously have (i) free capital mobility (financial flows) (ii) a fixed exchange rate and (iii) monetary policy autonomy. That is, on this diagram, all countries must choose a side:
But getting those advantages will come at a price. It means pivoting away from an export-led growth strategy that has been wildly successful over the last generation and has benefited from an artificially low yuan. It leaves China with greater risk of volatile capital flows that have created booms and busts, and bursts of inflation, in many other emerging economies over the years. And most importantly, from the vantage point of the ruling Communist party, it will mean ceding some of the power now held by top party officials to the hard-to-corral whims of markets.
There is likely a significant pent-up demand demand for yuan- denominated assets and the rest of the world would soon take advantage of the opportunity to diversify portfolios by investing in China. Furthermore, free capital flows would help the yuan to gain status as a "reserve currency" held by governments (it isn't one now because nobody wants to hold reserves in a currency they can't freely exchange). Purchases of Chinese assets by investors and governments would cause the yuan to appreciate (which would be partly offset by outflows as Chinese buy more foreign assets). This would hurt Chinese exports but raise its wealth and increase its consumption, helping to "rebalance" its economy toward a more consumer-oriented model (currently, consumption is about 35% of China's GDP, versus roughly 70% in the US).
China's policy of intervening to keep the yuan undervalued (relative to what it would be under a free float) means that its been buying alot of dollar-denominated assets. A reduction in this buying, as well as possibly lower demand for dollars from other countries if the yuan takes market share as a reserve currency, would mean a dollar depreciation. This would boost US exports, while lowering the purchasing power of consumers, thus rebalancing the US economy in the opposite direction of China's. In general, the financial inflows associated with the dollar's unique role have meant lower interest rates for the US - while this has been called our "exorbitant privilege", it is, at best, a mixed blessing, as it has distorted the US economy away from tradable goods production and helped fuel the previous decade's housing bubble. Ceteris paribus, the changes discussed above imply higher interest rates for the US, but for the immediate future, one would expect the Fed to try to make offsetting adjustments.
Allowing the yuan to appreciate would also make exports from other developing countries more competitive, and reduce the pressure on them to keep their currencies undervalued. That is, the biggest beneficiary of a shift by China might be Mexico.