Thursday, April 8, 2010

Why China is About to Change Its Currency Policy

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

Reports are out today, April 8th, that China is about to abandon its fixed rate currency policy instituted in July 2008. It is likely to let the renminbi revalue upward a small amount immediately and then trade in a narrow trading band on any give day after that. China took such an approach in 2005. The U.S. has been pressuring China for this change.

The Obama administration had a report that was supposed to be delivered to congress on April 15th on whether or not China was a currency manipulator. This has become an increasingly sore point in U.S. China relations. It was abruptly announced a few days ago that the report would be delayed. Treasury Secretary Geithner has since gone to China and met with officials to get them to be more flexible with the renimbi's exchange rate. The Chinese have remained adamant that their currency isn't undervalued. If that was indeed the case, they should simply let it float freely and everyone would be happy. There is of course zero chance that that is going to happen at this point in time.

Keeping the value of a currency artificially low is a boon for a country's exporters because it makes their goods cheaper. Business and labor interests in the country with the artificially high currency necessarily lose out. This is a good description of Japanese U.S. trade situation in the 1970s and early 1980s. Now China has a huge trade surplus with the United States and has accumulated approximately a trillion dollars in reserves of U.S. currency.  The U.S. gains from China's undervalued currency policy because China recycles the hoard of dollars its gets from its trade surplus by buying U.S. treasuries (Japan did the same thing). This allows the U.S. in turn to run massive budget deficits because it can borrow a lot of money from China. That game may be up however. China was a net seller of treasuries for three months in a row up to this January (the latest month for which figures are available).

Keeping a currency undervalued is not without its risks. One of those major risks is inflation. China has compounded that risk even further by engaging in a massive stimulus program while its currency was frozen. Inflation does seem to be bubbling up internally within the country and even beyond its borders in higher prices for commodities. Chinese buying is the key driver of commodity prices.  China is in fact the epicenter for potential global inflation and this will impact the U.S. despite any moves the Federal Reserve takes to try to dampen rising prices.

In the long-term, China will have to let the renminbi peg to the U.S. dollar, China will still need to maintain stringent capital controls to prevent big moves in its currency if the renminbi is inappropriately valued (many experts claims it would rise 40% if it floated freely).  Economic forces always win in the end and the Chinese leadership will eventually find this out.

ETNs that can be used to take a position in the renminbi are CYB and CNY.

Disclosure: None

NEXT: Currencies React to Ongoing Greek Debt Crisis

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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