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Understanding the M.A.D. China/U.S. Relationship

The big news this week has been the revaluation of the Chinese Renminbi (Yuan) against the US Dollar.  The markets were euphoric early Monday morning, but have since tapered off.  The reason for the tepid response is due to the rather tricky relationship between the United States and China.  For the last 23 months, China has kept a peg of 6.8267CNY per $1.   US lawmakers are continuously blaming the peg of the Yuan as the main cause for high unemployment  in the US, manufacturing moving overseas, a stagnating world economy, high debts in the United States, and anything else you would like to blame on someone else.  The truth is quite a bit more complicated.

In order to maintain the fixed peg against the dollar, the Peoples Bank of China (PBOC) must supply the necessary renminbi to purchase dollars to hold the currency fixed.  China’s significant current surplus, recently increased by strong capital inflows, means that significant quantities of base money are required to make this peg work.  Without some sort of offset, this rapid expansion of the domestic money supply would create massive inflation.  The PBOC “sterilizes this money creation by issuing short term bills and increasing the reserve ratio of the local banking system to soak up the excess liquidity and decrease the amount of lending that the banking system can affect.

The large current account surplus, capital inflows and currency peg force the PBOC to accumulate a massive amount of dollars.   The central bank then invests the bulk of its dollar reserve accumulation back into US Treasury securities.  China is increasingly dominating the global demand for treasuries and has therefore become the marginal buyer and rate setter in the Treasury market.

So what effect does this have?  The primary way that people think about it is that Chinese goods are kept cheap.  By keeping the Renminbi undervalued versus the dollar, it is cheaper for Americans to buy Chinese goods.  This is why US lawmakers blame the peg on unemployment and shifting manufacturing…because Chinese goods are too cheap.  The flip side of this argument is that Chinese goods are cheap.  If you need to purchase a good, then it is much better to purchase it at half price.

The more insidious aspect of this relationship is the artificially low interest rates due to the PBOC buying treasuries.  During the boom time when the Fed was tightening interest rates, the purchases by the central bank kept long-term interest rates low.  And now, when the treasury is issuing debt at an alarming and record-breaking rate, the peg has provided stability to US interest rates and has made it relatively cheap for the US government to continue issuing debt.  This is merely financing, the cheap cost of credit for the US consumer (Chinese goods buyer) has been created by the reduced borrowing cost for the US via Chinese treasury purchases.

As with all things, nothing can last forever.  Any country that pegs its currency to the dollar is effectively tied to US monetary policy.  So even if China’s economy is fine, the mere fact that the US is trying to fuel its domestic economy forces fuel into China’s economic fire.  For China, that pressure has fueled inflationary pressure.  This is why China has recently announced its relaxation of the currency peg.

But wait…there is more.  China cannot revalue its currency by 20% overnight.  By doing so, it would dramatically reduce demand for Chinese goods from US consumers, destroy the value of their treasury holdings, and possibly cause a spike in US interest rates which could cause the global economy to enter a recession once again.  This is Mutually Assured Destruction (M.A.D).

So what will happen?  China will slowly allow its currency to float in hopes that Chinese domestic demand will replace US consumer demand.  If this currency revaluation is successful, then we should see higher interest rates in the United States which will cause our own government to step off of the debt-fueled government spending and adopt our own austerity measures.  Let us all keep our fingers crossed.

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