Now what?

Is this more of a charade or a real step toward a tradeable yuan?

Is the Chinese government going to start telling the truth about its economy? (Will they try to do better than the US government?) Is there going to be a parallel change of non- economic policy in China to accompany the extension of the yuan into the nether parts of the world?

From the Virginia standpoint, China appears as a 21st century version of the Dutch East India Trading Company, using its ‘guilders’ as a means to exploit the locals of … Uzbekistan, Belarus, Argenina … what are those countries again? It would be positive if the Chinese were to free the yuan as a trading currency. It would force them to abandon that infernal dollar/yuan peg.

This is an interesting take from Stoneleigh at Automatic Earth. She describes the real US- China economic dilemma this way:

Now, let’s imagine Bernanke has a magic wand that he can wave to set the US inflation rate to 12%, in order to increase wages and revenues and make debt and prices manageable. A year passes. Everyone charges 12% more dollars for everything: labor, haircuts, cheeseburgers, and so on. That’s okay, because everyone earns more too. But every USD is still worth 6.83 CNY, and there was no inflation in China. That means the price of US labor, haircuts, and cheeseburgers is 12% higher in real terms in China. They can’t buy as much. That also means the price of Chinese t-shirts is 10.8% seems lower than it was last year, because Americans are all earning more. I’ll be more likely to buy things made in China.

China now exports much more to the US. With the proceeds from these exports and the intervention, they would buy more US assets, but less relatively expensive US goods and services. The trade balance worsens, the imbalances worsen, US workers and plants become even less competitive, China invests more in tradeables, US consumers go further into debt, and so forth. Less employment, less exports, more debt, stronger deflationary forces. Next year, things grow exponentially worse. Unless the US miraculously becomes more efficient and productive, to avoid this scenario, the US must have a weakening real exchange rate (REER). Because currency pegs prevent revaluation, that means China and Japan must run higher inflation rates than the US. Twisting it around, in current conditions, the US cannot run a higher sustained inflation rate than China, Japan, and others. The US must either:

1. Persuade China, Japan, and others to allow their currencies to appreciate dramatically so the US can abruptly default on some of its debt to them, and reduce their exports considerably;
   
2. Persuade China, Japan, and others to allow high domestic inflation. If the US wanted 12% inflation domestically, it might ask for 16% or 17% inflation in China, if not a bit more;
   
3. Do something crazy, like enact Smoot-Hawley Mark II and beat each other up at the WTO;
   
4. Suffer through deflation.

Now … times have changed. Instead of Bernanke’s 12% inflation there is 0.1% (official) inflation or unofficially -5% deflation. At the same time, un- under- employment is staggering toward 17%! Without USA inflation there is no Chinese competitive advantage built around the yuan/dollar peg. Instead, Chinese goods have become less valuable … that is they have less utility to their (potential) American customers than even a rock- bottom price would imply. Americans are too broke to buy anything, anyway!

At the same time, Stoneleigh’s option #2 has taken hold:

Persuade China, Japan, and others to allow high domestic inflation. If the US wanted 12% inflation domestically, it might ask for 16% or 17% inflation in China, if not a bit more;

China now allows a 7% rate of inflation relative to the US’s negative rate. This makes US products more ‘competitive’; GM’s Buicks are popular in China. It also loosens the peg … or does it?

China can either ditch the yuan/dollar peg or the ongoing deflation in the US will lever around it and amplify inflation in China. China needs to be very clever and astute at this point. Deflation makes the dollar (much) more valuable than assets including yuan, oil, real estate or Buicks – which are not assets but cash sumps. China can print yuan off those bucks and play at being a grown up country and take the risks that accompany that money supply increase.

One of the characteristics of countries during the last two years is having the various establishments look like idiots trying to keep both status and status quo intact. Printing yuan will amplify inflation in China. If there are enough monetary forces behind inflation in a country – and no balancing destruction of debt by deflation – there will be inflation.

While most Anglo countries are deep in debt and deleveraging … and experiencing deflation, the inflation danger is high in high- saving China.

Hu Xiaolian needs to convince her bosses in Beijing to lose the peg. It does China far more harm than good to keep it.