The big news out recently was China unpegged the yuan from the dollar. Almost everybody is going to tell you what a good idea it is — from Treasury Secretary John Snow down to those posting here. As those in Washington run to pat themselves on the back for forcing China’s hand, especially Sens. Schumer and Graham for their idiotic tariff bill, let me tell you why you shouldn’t be nearly as happy.

First, here are the details.

Since 1995, the yuan was pegged at 8.28 per dollar. The peg simply means that when the yuan became stronger, shown by the exchange rate falling, Beijing would buy up dollars and sell off yuan increasing the supply and driving down their price. Or when the yuan fell in relation to the dollar, they would buy yuan by selling dollars. Easy.

The first day the yuan was allowed to rise to 8.11 per dollar, up 2.1%. Each day the yuan will be allowed to trade within a 0.3% band, and in the next month 7.61 per dollar could be hit, an 8.8% increase. That’s a fairly substantial run up. The new yuan policy will be based on a basket of currencies instead of just the dollar, so the peg was loosened a little, but not removed. We don’t know what other currencies are in the basket or their weighting.

Second, it doesn’t really change prices.

The yuan is still kinda pegged to the dollar, just at a little higher rate and with a few other currencies in the mix. Prented the US dollar stays absolutely still along with all the other currencies, none rising or falling, Chinese prices under deflationary pressure will fall to cover the currency appreciation. If a gadget currently sells for 828 CNY, meaning it costs us $100 to purchase, after the yuan is allowed to rise to 7.61 per USD, prices will have to adjust too. China will deflate until the price level reaches equilibrium where the gadget costs 761 yuan. Not so surprisingly that still costs us $100: You cannot change the terms of trade by chaning the unit of accout.

While prices are adjusting you may be able to exploit the currency movements, but it isn’t going to even put a scratch in the trade deficit. In the meantime, while China’s prices fall to compensate for the stronger yuan, we get to pay more for goods. Revaluation supporters are telling us to believe that we will be better of if we have to shell out $110 for that computer motherboard instead of $100. I know my household is always much better off when we have to pay more for things. Nixon was sold the same line too, but then it was Japan and the Bretton Woods regime instead of China and her peg now. And we would all like to return to those halcyon days, right?

This is like arguing about if we should redefine the inch to be 12/13 of its current size so we can then put 13 of them in a foot and magically declaring yourself to be taller than before. Currency is a unit of measurement, and just redefining it doesn’t make the value of things change.

There is a potential disadvantage to this too. Part of the reason China has been buying US debt at higher levels has been because of this peg. When Beijing bought dollars to hold the peg, they needed someplace to put those non-interest bearing notes, so they bought interest bearing debt in the form of US Treasuries. If they don’t buy as many dollars as before, they may not buy as many bonds either. You might expect interest rates to rise as a result, and what do you know, they did the day China announced the changing of the peg, the ten-year rising a tenth of a percent. As soon as I got the news, I know what I went short.

Third, pegging to the dollar is actually a good thing.

We used to encourage everybody to peg to the dollar. During the Bretton Woods regime all major currencies were pegged to the dollar, and we had very good monetary stability. We even still encourage countries with underdeveloped monetary backbones to link to the dollar though currency boards of just directly dollarizing their economies.

Everybody already knows of two contemporary examples of large scale pegging. The United States is an example of all states sharing the same unit of account, and China is no different. Do you really think that California having a different currency than New York or Wyoming would be beneficial to either state? By China pegging to the dollar, we shared the same basic unit. We measured in cups, and they measured in eights of a cup. China imported Fed policy though the peg, because as the Fed managed the dollar China had to follow along. The other obvious example is the euro.

Here is the question though that supporters of the revaluation have to answer: If China were to dollarize their economy — they throw out the yuan and use US dollars for everything — would that be bad for us?

The peg is no different. For all purposes we shared a common currency with China. For all the claims that China is manipulating their currency, you can also read this now as “China is manipulating the yuan to the exact same extent as the US is manipulating the dollar.” The US is essentially complaining that China will not allow the US to devalue the dollar though loose Fed policy because their are devaluing the exact same amount. What a weird argument.

In the modern economy, all currencies float. The dollar floats, and the yuan floats too, just it floated with the dollar. The yuan is no more “pegged” than the dollar is pegged, because if the yuan is pegged to something that floats, then it must also float.

For all the complaining, when China was pegged to the dollar, it stabilized Chinese inflation, and a growing China helps American too. If China deflates, the almost half a trillion dollars in bad loans in the banking system could become much more of a problem.

Fourth, there is one good thing about the revaluation.

The Schumer/Graham 27,5% tariffs against Chinese imports are kicked down the street for now. However, this should have never been a problem in the first place.

Let history be your guide on this. Everytime you read an article extolling the virtues of the revaluation and how it will create jobs, remember that this has all been pushed before. The surest way to close the trade deficit is to just make everbody too poor to buy good from overseas. Recessions are great at that. Last time these monetary games didn’t create a great economy, so don’t expect it to this time.

Five, it might not even work as expected.

China has just moved to a basket. That mean they will take a weighted average of various currencies to determine the value of the yuan. Pretend for a moment that we know what the basket is: the US dollar, the Japanese yen, and the euro all in equal proportion. What happens when the dollar grows stronger than the yen and euro? Since the yuan is the average of the three, the dollar will actuall appreciate against the yen. This is the opposite of what the devaluation fans want. There is no guarnatee that the yuan will actually climb in value. The dollar has been ranged since the beginning of 2004, trying to break out higher, and if it does, this scenario could be possible. But we don’t really know about the basket or how things are working yet, so we this might not be possible if the basket isn’t fixed yet.

Remember when the nation was complaining about Japanese imports? I don’t, but I’ve read about it. The Japanese yen was growing stronger, and Japan was deflating away even as their exports to us increased. China will not be any different.

0 0 votes
Article Rating