China Drops Peg to Dollar

This surprised me, and according to Premier Wen Jiabao, it should have:

China Says It Will No Longer Peg Its Currency to the U.S. Dollar, Reuters: China bowed to months of market and political pressure on Thursday by revaluing the yuan by 2.1 percent and abandoning the currency's decade-old peg against the dollar.  ...  the central bank said the yuan's value from now on would be linked to a basket of currencies of China's main trading partners. … The central bank said the yuan, also known as the renminbi (RMB), would be allowed to move in a tight range of 0.3 percent up or down from the previous day's close in a continuation of the "managed float" policy in place 1994. … The big question for dealers was whether China would make use of the flexibility to let the yuan drift gradually higher.  "It's just a gesture. The question now is whether there will be continuing speculation that China may revalue even more," said Ben Kwon, an analyst from KGI Asia in Hong Kong.  China had long insisted that it would adopt a more flexible exchange rate system, but not until it was ready.  In March Premier Wen Jiabao impishly said the timing of a move would be a surprise … Greenspan said a yuan revaluation would have minimal impact on the U.S. trade deficit but urged China to adopt a more flexible currency for its own sake...

The question now is, as the article notes, whether this is a mere gesture without substance or if the yuan will be revalued further in the near future.  Thanks for the tip anne.

Comments

[pgl]

Kash of Angrybear has more. Brad S. notes that this 2.1% appreciation is very small.

[anne]

Though I have read the announcement several times, it is difficult to estimate the effect. This appears to be the beginning of a decline in Asian demand for American long term debt however, and that worries me.

[anne]

Should the effect simply be a 2.1% increase in value of the Yuan against the dollar, then there is no effect at all. If the Yuan is allowed to drift up in a controlled series of steps, then we may have an interest rate problem. Be careful what we wish for, but we are not careful.

[Movie Guy]

Gesture coupled with a few more surprises.

Watch.

This should be entertaining.

[anne]

Notice that the effect of the Chinese currency peg revision has at first been to leave the dollar strong as before against the Euro and the Yen, but to cause a rise in long term bond yields.

[DMY]

Krugman says:

"An end to China's dollar-buying spree would lead to a sharp rise in the value of the yuan. It would probably also lead to a sharp fall in the value of the dollar relative to other major currencies, like the yen and the euro, which the Chinese haven't been buying on the same scale. This would help U.S. manufacturers by raising their competitors' costs."

Can someone explain the last statement on how it would help U.S. manufacturers? Thanks!

[Mark Thoma]

When the yuan appreciates, China's exports become more expensive to other countries, and its exports should fall. When the dollar depreciates, U.S. goods become cheaper to other countries and exports should rise (and imports of Chinese goods should fall). Both effects are good for U.S. manufacturers.

The second part is that China imports a lot of its raw materials. These will get cheaper offsetting some of the disadvantage from appreciation of the yuan, but on net it should cause Chinese goods to become more expensive and therefore reduce U.S. imports of them. This helps U.S. manufacturers since Chinese goods are more expensive in the U.S.

Hope this helps.

[Betsy L. Angert]

Dear Mark . . .

Is it true; this will mean an increase in mortgage interest rates in the United States? Might this be the bubble bursting?

One source said people would be reluctant to buy homes; the rates will inevitably be higher.

I also understand this will affect the price of oil.

China has been and continues to be an interesting study.

I ask. As far as the yuan goes, I know nothing, or very little. Please teach me!! I have read a bit, heard a smidgen more, and still, I am learning.

With appreciation . . .
Betsy L. Angert Be-Think

[anne]

http://www.nytimes.com/2005/07/22/opinion/22krugman.html

China Unpegs Itself
By Paul Krugman

Thursday's statement from the People's Bank of China, announcing that the yuan is no longer pegged to the dollar, was terse and uninformative - you might say inscrutable. There's a good chance that this is simply a piece of theater designed to buy a few months' respite from protectionist pressures in the U.S. Congress.

Nonetheless, it could be the start of a process that will turn the world economy upside down - or, more accurately, right side up. That is, the free ride China has been giving America, in which the world's richest economy has been getting cheap loans from a country that is dynamic but still quite poor, may be coming to an end.

It's all about which way the capital is flowing.

Capital usually flows from mature, developed economies to less-developed economies on their way up. For example, a lot of America's growth in the 19th century was financed by investors from Britain, which was already industrialized.

A decade ago, before the world financial crisis of 1997-1998, capital movements seemed to fit the historic pattern, as funds flowed from Japan and Western nations to "emerging markets" in Asia and Latin America. But these days things are running in reverse: capital is flowing out of emerging markets, especially China, and into the United States.

This uphill flow isn't the result of private-sector decisions; it's the result of official policy. To keep China's currency from rising, the Chinese government has been buying up huge quantities of dollars and investing the proceeds in U.S. bonds.

One way to grasp how weird this policy is would be to think about what a comparable policy would look like in the United States, scaled up to match the size of our economy. It's as if last year the U.S. government invested $1 trillion of taxpayers' money in low-interest Japanese bonds, and this year looks set to invest an additional $1.5 trillion the same way.

Some economists think there is a deep rationale for this seemingly perverse policy. I think it's something the Chinese government stumbled into as it tried to protect itself from the 1997-1998 crisis, and it is reluctant to change because the Chinese economy has been doing well. That is, China's leaders don't want to mess with success.

But pressures against China's dollar purchases are building. By keeping the yuan down, China is feeding a trade surplus that is creating a growing political backlash in America and Europe. And China, which is still a poor country, is devoting a lot of resources to the accumulation of a basically useless pile of dollars instead of to higher living standards.

The question is what happens to us if the Chinese finally decide to stop acting so strangely.

An end to China's dollar-buying spree would lead to a sharp rise in the value of the yuan. It would probably also lead to a sharp fall in the value of the dollar relative to other major currencies, like the yen and the euro, which the Chinese haven't been buying on the same scale. This would help U.S. manufacturers by raising their competitors' costs.

But if the Chinese stopped buying all those U.S. bonds, interest rates would rise. This would be bad news for housing - maybe very bad news, if the interest rate rise burst the bubble.

In the long run, the economic effects of an end to China's dollar buying would even out. America would have more industrial workers and fewer real estate agents, more jobs in Michigan and fewer in Florida, leaving the overall level of employment pretty much unaffected. But as John Maynard Keynes pointed out, in the long run we are all dead.

In the short run, some people would win, but others would lose. And I suspect that the losers would greatly outnumber the winners.

And what about the strategic effects? Right now America is a superpower living on credit - something I don't think has happened since Philip II ruled Spain. What will happen to our stature if and when China takes away our credit card?

This story is still in its early days. On the first day of the new policy, the yuan rose only 2 percent, not enough to make any noticeable difference. But one of these days Chinese dollar purchases will trail off, and we'll find ourselves living in interesting times....

[anne]

Essentially nothing has happened. China would prefer not revalue the Yuan against the dollar, and evidently have only pretended to do so. That should leave interest rates low, which is a relief, but leave the balance of trade deficit intact and growing rapidly as before. Should we be relieved? I am.

[anne]

Investors seem to be gauging the currency issue as being of no real market difference so far.

[anne]

Paul Krugman

'Some economists think there is a deep rationale for this seemingly perverse policy. I think it's something the Chinese government stumbled into as it tried to protect itself from the 1997-1998 crisis, and it is reluctant to change because the Chinese economy has been doing well. That is, China's leaders don't want to mess with success.

'But pressures against China's dollar purchases are building. By keeping the yuan down, China is feeding a trade surplus that is creating a growing political backlash in America and Europe. And China, which is still a poor country, is devoting a lot of resources to the accumulation of a basically useless pile of dollars instead of to higher living standards.

'The question is what happens to us if the Chinese finally decide to stop acting so strangely.'

We still have to assume China will come to understand that it is not in her interests to support the American deficit, at least not to the extent it has done so. The peg is inherently unstable over time, but does it ever look stable until it really is removed.

[Betsy L. Angert]

Dear Anne or anne [uncertain which is your preference and I wish to honor that] . . .

I thank you for the information, though I fear that, just as in life, theatre is not separate from reality. It is often said, "life is a stage.” All is a cause and ultimately, there are effects.

As Paul Krugman writes, “it is all about which way the capital is flowing,” ebbing and flowing.

Betsy L. Angert Be-Think

[anne]

Thank you, Betsy. I like the life as theater metaphor, but I am not sure how you are using it in this context and would like to know. What are you thinking?

[anne]

The investment relationship between China and America is astonishing. American households save little, the Chinese save a lot. The Chinese are using their household saving to finance our spending even though we are far more developed than China. We should be investing heavily in China and the Chinese should be investing at home as well as the gulf in development between our countries is narrowed. Now there is American investment in China, since corporate saving is high and corporations are investing in China. Also, there is substantial infra-structure investment in China by the communist government. But, there is this curious purchase of dollars by the Bank of China that would seem to run counter to her own interests and still no telling how long such purchases will go on.

[DMY]

Mark,

Thanks for your clarification. So now that we can expect the U.S. to reduce their imports from China, where are we going to pick up the slack? Are we going to rely on U.S. manufacturers?

[anne]

But, keep in mind that the change in currency status by China as of now will have virtually no effect. Possibly this is a beginning, but nothing has changed yet that will meaningfully slow the accumulation of American foreign debt.

[anne]

Paul Krugman thinks back to the Spain of Philip II, but we are not really the Spain of any era, yet I can not imagine a world power that in several hundred years has left itself dependent on international financing to meet its obligations. We have a serious internal and external debt problem. We may continue accumulating foreign debt for years to come, but basically what we are doing as Warren Buffett has pointed out is selling off assets internationally to support current consumption levels and there must be a limit somewhere.

[anne]

http://www.msci.com/equity/index2.html

National Index Returns [Domestic Currency]
12/31/04 - 7/20/05

Australia 10.0
Canada 13.7
Denmark 22.0
France 18.6
Germany 13.1
Hong Kong 8.2
Japan 3.5
Netherlands 17.7
Norway 26.0
Sweden 19.1
Switzerland 16.6
UK 10.1

[anne]

http://www.msci.com/equity/index2.html

National Index Returns [Dollars]
12/31/04 - 7/20/05

Australia 5.8
Canada 11.5
Denmark 7.4
France 4.8
Germany -0.1
Hong Kong 8.2
Japan -6.7
Netherlands 4.0
Norway 15.1
Sweden 0.6
Switzerland 1.9
UK -0.9

[anne]

http://flagship2.vanguard.com/VGApp/hnw/FundsVIPERByName

Sector Indexes
12/31/04 - 7/20/05

Energy 26.9
Financials 1.0
Health Care 7.3
Info Tech 1.0
Materials -1.6
REITs 11.5
Telecoms 0.7
Utilities 16.4

[anne]

http://flagship5.vanguard.com/VGApp/hnw/FundsByName

Vanguard Returns
12/31/04 to 7/20/05

S&P Index is 2.9
Large Cap Growth Index is 3.0
Large Cap Value Index is 4.3

Mid Cap Index is 9.0

Small Cap Index is 6.6
Small Cap Value Index is 7.0

Europe Index is 2.0
Pacific Index is -2.5

Energy is 27.9
Health Care is 8.7
Precious Metals 9.8
REIT Index is 11.4

High Yield Corporate Bond Fund is 1.5
Long Term Corporate Bond Fund is 5.8

[Betsy L. Angert]

Dear Anne or anne . . .

You asked of my use of the metaphor and how it parallels this particular subject.

Paul Krugman writes, “There's a good chance that this is simply a piece of theater designed to buy a few months' respite from protectionist pressures in the U.S. Congress.” He continues, “Nonetheless, it could be the start of a process that will turn the world economy upside down - or, more accurately, right side up.” He concludes, “But one of these days Chinese dollar purchases will trail off, and we'll find ourselves living in interesting times....”

My thought, in some ways reiterates Krugman’s. Theatre is not predictable. Yes, there is a plot, a scene, and a belief that the audience or actors will act or react in a particular manner. However, nothing is as expected; nor can it be predicted. Each audience member will interpret the same differently. Each performer, on any given night will not be able to replicate an earlier performance. Life looks as though it can be predetermined; it cannot be.

If you study quantum physics you know that particles are not predictable. There are influences, both seen and invisible. Every entity affects another. The best laid plans . . .

Experience is unique as are the opinions of experts. Conjectures are similar, but never exactly the same.
China may have designed this move as theatre; however, their economic professionals cannot know what it will bring with certainty. There is drama, trauma, chaos, calm, peace and serenity. We can only surmise.

Do remember when David Stockman denounced his once held, strong belief in the trickle-down theory.

Sam Walton theorized he would bring low prices to big cities; he would benefit the people. Did he know he would destroy the middle class [my opinion!], create a world power in China, and obliterate the competitive market [my opinion!]. I hope not. If he did, how diabolical. Since I prefer no one intends to be cruel . . .

Betsy L. Angert Be-Think

[anne]

Since years ago, I signed with a small letter I left the letter small. A conceit :) But, I answer to any form of Anne. That was a remarkable and lovely explanation, and inherently true. Your fine insight is more important to me than than the issue at hand, for in theorizing I can play at imagining that life plays out in a far more determined way than ever it could have or can. I agree with you about the indeterminacy and the metaphor will help me remember this.

Am I ever glad I asked. When I can think more clearly, I will remember the theatre metaphors that were flitting about from Hamlet or Macbeth and they will be better understood for your comment.

[Betsy L. Angert]

Dear anne and any others . . .

Hours after my last comment, I realized that a sentence of mine could be easily misinterpreted. While many might not notice or find it important, misstatements haunt me. Therefore, I am writing a correction or clarification.

I find it fascinating, even humorous, that China is becoming a global-super-power. I think the growth of this nation may advance healthy reflections and realities. I do not profess to know with certainty. I only have my opinions. As I gain knowledge, these may change. I am open to learning and love the process.

I recognize there are persons in the United States that are threatened by China’s growth; I am not. I find the distress that some express entertaining. There are those that do not want China to consume as America does.

I did not intend to connect my thought on China’s newfound strength with those on the middle class or the survival of small businesses.

Anne, I thank you for the compliment on my explanation.

When chatting with me, ask anything. For me, without questions there is no true knowledge. If we trust only the limits of our own minds, we know very little. I rather lean, share the wisdom, and realize that all is forever evolving.

A pleasure . . .

Betsy L. Angert Be-Think

[anne]

http://www.nytimes.com/2005/07/23/business/worldbusiness/23dollar.html?

China and the U.S. Embark on a Perilous Trip
By LOUIS UCHITELLE

'The circumstances seem to be as dangerous and intractable as any I can remember,' Mr. Volcker said Thursday, repeating an earlier warning in a February speech. 'If people lose confidence in the dollar as a store of value, or lose confidence in the political strength of the United States relative to other countries, there is going to be trouble. I'm not saying a crisis is inevitable or that an orderly adjustment is impossible, but at some point big adjustments will have to be made.'

The problem stems from America's persistent buying of much more from other countries, particularly China and Japan, than those countries purchase from the United States. The payment for the imports is in dollars, and because the foreigners do not use all of the dollars to make offsetting purchases here, they lend the excess back to Americans, who then use the loans to purchase more from abroad.

That satisfies this country's desire to consume and Asia's desire to step up production and employment for its vast population. But America's indebtedness to the rest of the world is rising at an annual rate approaching $700 billion. Everyone agrees that this indebtedness cannot continue to go up indefinitely. But while the pessimists see a sharp painful correction in the not-so-distant future, the optimists, a camp that includes the Bush administration and much of Wall Street, argue that the present arrangement is quite sustainable....