RSSExpect Acceleration in the Appreciation of the Yuan
 | Seed Newsvine |
Rapid price inflation in China – over 7% in January 2008 − will likely lead to a greater appreciation in the value of the Yuan this year, versus the U.S. dollar, than at any time since a partial float was first permitted in July 2005. The logic for this flows from the close economic ties between the two countries.
China’s 10%-plus real growth rate over the past several years has been largely fueled by huge U.S. consumer demand for low-cost Chinese goods. To pay for such items, U.S. dollars first have to be exchanged for China’s currency, the Yuan.
Normally, this would drive up the price of the Yuan and, eventually, reduce demand. But since the price of the Yuan is semi-fixed, the Chinese central bank has satisfied the demand for more Yuan by creating more (broadly-based) money. The inevitable result has been a run-up of prices within China.
The standard means to check rising inflation is to raise interest rates and that’s what China’s central bank has done, to a limited degree. (China’s nominal interest rates are still artificially low and, in real terms, may even be negative.) However, the higher nominal interest rates in China have now created an interesting dilemma. China’s central bank may be starting to lose money on its international investments.
The U.S. dollars that China has acquired over the years have been invested in U.S. Treasury Bills. Now, U.S. interest rates are falling. China’s central bank is being squeezed between the high (and potentially moving higher) rates it is paying domestically and the falling returns it is receiving from overseas.
Nor can China simply move to withdraw its holdings in the United States. Such action would hurt its largest customer. The U.S. Federal Reserve would be forced to reverse its current policy and raise rates in order to hold onto foreign capital, thereby deepening the U.S. slowdown/recession.
Steps to keep inflation in China down include temporary price controls on food, fuel and some public services. However, the easiest and most obvious fix would be to allow a more rapid appreciation in the value of the Yuan. This would have an immediate impact through lowering import prices. It would also rein in too rapid, inflation-inducing growth in the overall economy, through making exports more expensive.
(This entry is partly based on several recent articles in The Economist magazine.)
Alex Carrick
