China's Currency Peg and Bubbles

The global economy is characterized by enormous imbalances, particularly the $2 trillion or so in reserves parked at the People’s Bank of China.  This build-up of reserves is one culprit of the asset-driven economy.

Make no mistake, our problems are not because of China.  Our problems are because of ourselves.  But China’s currency peg has dramatically exacerbated the problems of the global economy.

The past decade has been characterized by two of the most deflationary forces of our time – the Internet and the inclusion of China as a major player in the global economy.  The Internet is deflationary because of dis-intermediation – it cuts out the middleman, lowering costs for consumers.  The opening of China is deflationary because its wages are low, effectively lowering the global cost curve for corporations.

In a balanced economy, these deflationary forces should have caused prices to fall.  However, prices did not fall.  The Federal Reserve would not allow that to happen.  To keep prices from falling, the Fed injected money into the economy to keep prices stable.  That money had to go somewhere, and it went into asset markets.

China supplied us with cheap goods and ran a massive trade surplus.  The yuan should have risen against the dollar, but the Chinese government would not allow that to happen, and China built up a ridiculous amount of reserves.  Had the yuan risen, Chinese labor would not have been so cheap, and the deflationary forces emanating from China would have been less.  With less deflation, less money would have been created and less liquidity would have flowed into asset markets.

With trillions of dollars in reserves, China had to put that money somewhere.  Much of China's reserves were recycled back into the US Treasury market, increasing demand for Treasuries which lowered interest rates.  Lower interest rates allowed people to finance purchases of assets cheaply – from homes to CDOs  – fueling the housing bubble.  Had China not pegged its currency to the dollar, it would have had fewer dollars to recycle into the US bond market, demand for bonds would have been less and interest rates would have been higher. Had interest rates been higher (and the Fed could have kept rates higher regardless of what China did) then there would have been no housing bubble, or at least the housing bubble would not have grown as large as it did. 

(This criticism can also be labeled at Japan and other Asian countries whose economies were geared towards exports to the American consumer.  They too ran up enormous currency reserves.)

Over the long run, a floating yuan is good for the global economy.  It will clear out many of the destabilizing structural imbalances.  It is good for China as well.  A rising yuan will increase consumer spending in China as imports become cheaper, re-balancing the Chinese economy away from its heavy (and unhealthy) reliance on exports and capital spending.

In the near and intermediate-term, however, it is bad for our asset markets.  A rising yuan means less demand for Treasuries, which means higher interest rates, which means less support for asset markets such as stocks, bonds and housing.   In our asset-driven economy, less liquidity is bad for our markets.

In the long-run, a floating yuan is positive for the US economy.  Our heavy reliance on asset markets is unhealthy.  Less trading things and more making things is ultimately good for America.

Comments

[Tipton]

Chinese Yuan pegging against doller is dangerous for US economy.

China pegging its Yuan againt US dollar that keeps its manufactured product artificially cheap all over the world. It’s a cheating method of trade. It seems like China is intelligent and importing countries are fools.

At present China have some competitor ( like Thailand, Indonesia, Vietnam, etc ) so China selling its product very cheap. Now factories in other countries starts closing because they can’t competate with China ( Unfair trade practice ). So in future, there will not be any competitor for china. That time, China will increase their product cost and sell their goods for heavy profit. For USA it can’t find an alternate for China and can’t open factories immediately. Totally US economy will be spoiled. China became the “ King of the world “.

At present it looks like China is dependent on US import but in future US became slave for Chinese export.

This is the last chance for US to save its own economy from Chinese economic trap.

If Obama afraid and didn’t take any bold action against Yuan pegging, US will be in miserable state.

This is same for all countries which depend on Chinese import like UK, European Union, India & Brazil. They should wake up and put end to this Chinese monopoly trade.

[psychodave]

I just want to know how China was able to maintain the peg so successfully.

I anticipated that such a long term sterilization of yuan printing to sustain their target peg was unsustainable, and would result in debilitating yuan inflation. I was dead wrong.

How did they do it?

[Ross]

Makes you wonder just how long this can go one for doesnt it!

[Account Deleted]

In most major economies using coinage, copper, silver and gold formed three tiers of coins. Gold coins were used for large purchases, payment of the military and backing of state activities.