A Taller Yuan: A Good or a Bad Thing?

My friends over at China Law Blog have asked my opinion as to "whether the U.S. would be better or worse off if the Yuan [were allowed] to float and, presumably greatly appreciate."

I'm glad you asked. (Any excuse to bloggiate.)

My answer is: That depends on whether you care about the immediate (read short-term) effects or the long-term ones.

Obviously, if the yuan floats, it goes up, and the dollar goes down, which I believe would only give a more truthful reflection of long-term reality. But just as obviously, both China and the US are profiting short-term from this pegging, in spite of all of the jaw-boning. China is raking in the dollars for cheap exports, and the US is getting a low CPI with a cute angelic halo around Greenspan's (now Bernanke's) head to help camouflage the Fed's misguided "economy-rescuing," credit-pumping, bubble-blowing activities.


[Thanks to dioshaciendoelmilagro.com for the image.]

I watch the yuan chart on a daily basis, and it's absolutely mind-boggling and very unique among foreign exchange charts. What would be the immediate results of an unpegging? Havoc in the Chinese export industries. But it's also the end of the party on the other side of the Pacific.

Chinese companies will have to slow production in compliance with receding American demand, we know that; but do we also realize that America will have to come to terms with the resulting increase in prices and (here's the rub) the increase in our all-important CPI inflation rate -- a bogus figure if there ever was one, but nonetheless an instrumental one with regard to our monetary policy?

The second ramification would be havoc -- or further havoc -- in the Chinese and our own speculative asset markets. If I understand correctly, much foreign investment has already found a home in China just waiting for such an appreciation, so much so that the Chinese government has felt the need to take action to suppress it, in order to avoid undue asset inflation and the damages such as those done to the Icelandic economy when all of the speculative money tide left its shores. American money probably makes up the bulk of that speculative activity.

The third problem has to do with worldwide confidence in the dollar. As the yuan increases in value, the dollar sinks, and along with it all dollar-denominated assets and investments; and I don't think it would sink only respective to the yuan. The exchange markets, like all markets, are easily spooked, and a sudden dollar drop might topple us all into a flight away from it.

On the other hand, all of this is going to happen sooner or later, in my opinion; it's just a matter of time and speed. It may appear as a flight from the dollar, as a walk away from the dollar, or as a relatively unnoticed drop in the foreign exchange rate of the dollar without any repercussions on the internal economy -- although in this internet-investing day-and-age, I can't believe it would happen that smoothly.

Bernanke wants desperately to control this American economy. He doesn't want a yuan problem messing things up. He's already got a Catch 22 on his hands: If he raises rates, he'll put the squeeze on the American credit-bloated consumer. If he holds rates steady, he's sending the signal that the Fed will no longer pursue its corrective activities, which might send bonds plunging, the Dow into another roller coaster ride, and gold off the charts.

Whatever the Chinese decide and/or can do, I believe the dollar is overvalued relative to the amount of purchasing media in circulation; but I also believe that the world is not quite ready to move on to some other currency. Where else would you go? (Except gold...)

All of this is moot, of course, as long as China can hold onto their yuan. To date, they have expressed no intention of letting go, in fact quite the contrary. China Law Blog gives us some good insight into the reasons for this; see here.