Chinese Yuan–USD Peg - the operational issues revisited

Posted by on 17 November 2009

China is under pressure to alter its peg to facilitate the Yuan appreciation. But such a move has far reaching consequences. I shall try to revisit some of them. Let us assume for a while, that they actually heed our suggestions and relax their currency control - a little bit.

What will happen? -
Of-course, an immediate impact on their exports' potential. It will be under pressure as the currency appreciation could prove dear to existing purchasers, who must have entered long term contracts long time ago. This appreciation will correspondingly push their procurement costs. That they pass onto their customers who are primarily across EU, & USA - onset of inflation in short term. This is the last thing these economies want. Things can change slightly depending on whether the contract is made in Yuan or USD/EUR/foreign currency.

Probable extent of appreciation:
Since 2005 China relaxed its peg and let Yuan appreciate. Since then RMB appreciated around 20%. If we take that into account with the above assumption, the probable appreciation could be around 5% within next 1 year. That means an immediate increment of similar or even higher proportion of COGS (cost of goods sold) to US & EU importers. So we will have another reason for immediate short to medium term inflation, when and where it is most unwanted. Also an appreciation of 5% means, with a high export oriented trade from China to these states US, EU could experience a further widening trade gap. That will further depreciate USD/EUR etc. against Yuan.

Further discussion on consequences of Yuan appreciation:
There are a few other aspects that we look a little deep, if the Chinese were to change the currency peg. We are aware that once the Yuan’s further appreciation is allowed, there is an additional component to inflation rate growth. This poses significant challenge. The central banks across all major economies will be under pressure to ensure that the rate of inflation growth is contained. Either they may be forced to prematurely withdraw some or all of the special liquidity measures that supported the global financial system or they may push the interest rates. In this benign market environment, any such a move will have several undesired effects. One of which is on the currencies. USD or EUR will climb up as the rates are moving high. Even though that is moderately desired by respected governments (as expressed by senior US administration officials and FED governor) global markets and participants have more imminent threat. They have to either urgently unwind their USD carry trade or they have to incur losses. This unwinding will result in significant correction in the global equities space. The borrowing costs will move higher up as a second consequence from the upward movement of interest rates. The liquidity withdrawal measures and or interest rate push will also have a telling impact on banks lending to the broader economy.

Leaders and academicians across the spectrum argued that tight Yuan-USD regime is adversely affecting the competitiveness of other countries. President Obama observed that a country’s growth need not have to come at the expense of others and that it is not a Zero sum game. Even though it is true that Yuan’s further appreciation will help countries like Indonesia, Viet-nam and so on to grow as an alternative to Chinese manufacturing, they can only do so in medium to long term as they have to establish additional capacities to capitalize on this changing trend. As this will not be an over-night development, the inflation thereat is only reinforced. This inflation is for all us.

Domestic issues for the Chinese:
Bloomberg states that there is 29% more money supplied to the domestic Chinese market since recession. USD 150Bn was also invested into China through speculative funds as a means to hedge declining dollar.
If the Chinese do let their currency to appreciate, in the medium to long term there is a strong inflation upsurge in China as a consequence of their domestic lending and heightened liquidity supply. They did so to partially offset the demand loss due to crises. This lending so far has improved internal consumption and reduced idle capacity. However as the global economy is reviving, there is an upsurge in Chinese manufacturing or shall we say the return of demand, which will again have to be catered by the existing capacity. Even though the Chinese government can control the lending and hence shape the internal demand/consumption; that will only happen in medium term. If the government changes reserve ratios, stock market will take it negatively. If they change the rates, markets will not take it kindly either. Also the surging interest rates will not help recovery of loans made recently. Defaults could prove costly for broader economy. Therefore until the system is out of its transition phase of appreciating currency, they will have inflation threat right away. The inflation and the fight against it within China are not going to help their financial markets. Why would they do some thing like that?

End of part 1.

Part 2 will attempt to explore some solutions

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