Free Floating Yuan = Stronger Yuan ??

An interesting assumption in virtually all debates concerning the Yuan is that it would appreciate against the Dollar, once let float freely. A good example is the article below in which this premise is applied, set in stone and unquestioned from start to finish:

A growing number of global leaders are urging China to look to its long-term interests and allow its tightly controlled currency to rise. But they are encountering reluctance from a government still very much worried about the economy in the short term.

President Barack Obama and Dominique Strauss-Kahn, managing director of the International Monetary Fund, in Beijing on separate visits Tuesday, told Chinese officials that yielding to market pressures for a stronger yuan would help the global economy recover.

Nonetheless, Chinese President Hu Jintao didn’t announce any new commitment on currency policy to Mr. Obama. Other Chinese officials and economists continue to defend China’s policy of keeping the yuan steady against the dollar to aid Chinese exports, which are still vital in sustaining the nation’s economic recovery despite growing domestic consumption.
[Geithner] Reuters

Treasury Secretary Timothy Geithner took a softer tone on China’s currency at a Senate Foreign Relations Committee hearing on Tuesday.

At a congressional hearing Tuesday, Treasury Secretary Timothy Geithner sounded a much softer tone than in the past on China’s currency, saying it’s “very important” that the Chinese government pursue “broader reforms to their exchange system over time.”

“China has to take steps to move away from excessive reliance on exports” and find ways to stimulate domestic consumption, Mr. Geithner said at the hearing before the Senate Foreign Relations Committee, refraining from harsh rhetoric toward the Asian giant. He said that China is already making progress on rebalancing its economy and that “we’re seeing very promising, early signs” of a shift toward growth that relies on “domestic consumption and investment.”

The discussions highlight how China’s heavily managed currency is once again at the center of debates over global economic policy, after being pushed to the background by the financial crisis.

Though Mr. Hu, Mr. Obama and other world leaders have promised to cooperate in pulling the world economy out of its deepest slump in a generation, coordinating economic policies across very different countries remains difficult.

High unemployment makes trade with China a volatile political issue in the U.S., but similar pressures make it difficult for China to yield to U.S. pressure on the currency. A stronger yuan would make Chinese exports less competitive, which is unappealing for China in a year when exports are down about 20% and many manufacturers have closed.

Chinese leaders who have criticized the West’s economic management may also find it politically difficult to yield to demands on the currency.

On the other hand, China’s economy has recovered faster than most. Because the yuan has weakened sharply against other currencies, European and Asian competitors complain that China has an unfair advantage.

Meanwhile, some economists worry the extra juice to the economy from the cheap yuan, in addition to huge government stimulus, risks new bubbles in real estate and stocks.

Mr. Strauss-Kahn said keeping the currency down may help exports in the short term, but it imposes other costs. “You have to balance your needs in the short term with the long term,” he said. For instance, an undervalued currency encourages companies to invest in ways that may not be viable once the currency rises.

“If you have wrong prices, you make wrong decisions, especially concerning investment in the long run,” he said, adding that it is time for China to look more toward long-term stability now that it has accumulated advantages from an undervalued currency.

A stronger currency also would boost the purchasing power of Chinese households, which would support the Chinese government’s drive to make economic growth less dependent on exports, Mr. Strauss-Kahn said.

Chinese officials frequently counter that big swings in the exchange rate can harm companies and disrupt the economy, which is of particular concern at a time when confidence is fragile. They sometimes contrast the stability of the yuan’s exchange rate — which makes it easier for firms to plan ahead — with the wild swings in the dollar’s value.

“China keeping a basically stable exchange-rate policy is, in reality, good for the global economic recovery,” Yao Jian, spokesman for China’s Ministry of Commerce, told reporters Monday. “If the request is to strengthen other currencies, while allowing the dollar to keep weakening, that’s not very fair.”

Chinese officials aren’t totally closed to arguments for a stronger yuan. In a statement many interpreted as a gesture to the growing concerns about the currency, the People’s Bank of China last week said exchange-rate policy would take into account “changes in international capital flows and the trends of major currencies.”

Still, many private analysts don’t think a move on the yuan is imminent.

Authorities may feel freer to shift once exports are growing again and inflation has turned positive, which could happen early next year. In coming months, China will have to tell other members of the Group of 20 leading economies how it plans to boost consumer spending.

Although China’s government publicly has grown more confident about the strength of its recovery, growth still remains heavily dependent on government stimulus programs.

“China needs the U.S. economy to recover strongly and renew its import growth. Otherwise, China will have a tough time sustaining its recovery,” said Eswar Prasad, an economist at Cornell University.

That is one of the key reasons China is reluctant to lift its currency now. World Bank chief economist Justin Yifu Lin, a former Chinese government adviser, has argued that if a stronger yuan snuffs out a recovery in China’s export sector, it could weaken China’s entire economy and have negative consequences for global growth.

As I noted before on this matter (and so far I see no reason to change my mind on that):

Some points fundamentally support the thesis that the dollar should gain in value against the major currencies:

– Global deleveraging is driving investors from other currencies back to the Dollar
– Deflation hitting the US first, and other countries only later
– Imports into the US are falling rapidly
– Significant domestic spending sprees by the Chinese government

All this may indicate that if the Chinese government were to let the Yuan float freely at some point, it may actually drop significantly against the US Dollar. Such an event could possibly be the ignition for a significant Dollar rally in the years to come.

We will see how things develop over time. I am not saying that my scenario HAS to occur. But I think it certainly is a possibility over the next 2 years or so. What I reject is a completely one-sided approach to this question. As Ayn Rand always used to say: Whenever you encounter contradiction in your thinking, check your premise. I will surely check mine if I turn out to be wrong.

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6 thoughts on “Free Floating Yuan = Stronger Yuan ??”

  1. Hi Nima,

    Peter Schiff has this article up over at C4L:

    The Truth Behind China’s Currency Peg

    In it, Schiff also assumes that the renminbi will rise against the dollar if the peg is removed. How about making the case for the dollar gaining in value vs other major currencies if the yuan was allowed to free float in the comments to his article? If he responds, it would make for an interesting debate.

    One problem I have with Schiff is that he doesn’t seem to want to acknowledge or take into account the possibility that credit bubbles around the world are as bad or worse than ours. He seems to assume that everyone else is in better shape than us. This is why Mish won me over on the inflation/deflation debate. Schiff doesn’t go far enough in his analysis. He stops with the Fed is printing money. Yes, the government is printing money, but, credit is being destroyed faster than they are printing. Hence, we are currently in deflation. The inflation already occurred with the expansion of credit during the housing bubble.

    I’ve never heard Schiff respond to the deflationist argument, instead he and Mish only seemed to launch personal attacks at each other. Although Mish endorsed Schiff for Congress, it seems there is too much bad blood there to get a civil debate going on the issue. It would be interesting to see if you could engage him in a debate about your premise that the dollar may rise against the yuan if it was allowed to float freely and about the deflation argument. In any event, thanks for giving us the other side of the argument.


  2. Neat! ” … the US Dollar is poised to become the next iteration of the Volkswagen short squeeze …” very nice comparison indeed!

  3. Ah, regarding your comments above: I am not sure if one can engage Schiff in any such debate right now. He did not even attempt to deal with Mish’s valid arguments, instead he referred to Mish as “this guy” on his show and continued his standard platitudes.

    I also support Schiff for Senate, and agree with him on all his policy recommendations.

    I think it is crucial and important to challenge false policy recommendations due to their disastrous consequences for the many disenfranchised and poor people they affect. As far as such concepts are concerned it is crucial to sternly distinguish between right and wrong, true and false.

    But I’m not so keen on engaging in a petty little debate about how this or that currency or commodity or stock or interest rate will fare down the road. Time will tell soon enough.

    Heck, Schiff has a campaign to win now, he should focus on that! I’d much rather see him in politics than talk about hyperinflation all day. It’s where he belongs and he needs to focus all his efforts on that, not what I have to say about the Yuan or Treasurys or deflation.

  4. I support Schiff for Senate, too. It’s just too bad he doesn’t seem open to answering any questions challenging his positions. I believe it is always best to consider all possibilities/scenarios and hope he is not as blinded by his zealous belief in hyperinflation as those currently in charge are by their zealous belief that more stimulus will get us out of this economic crisis.

    Just saw this regarding the possibility that the yuan may devalue:

    Tracing the History of China’s Forex Reserves and Trade Balance

    Thanks for all of your hard work on your blog! Have a Happy Thanksgiving and keep up the great work!

  5. I happen to think that, seen from a political standpoint, paranoia about hyperinflation can only be a good thing. And the more of it the better. For what is the worst thing that could happen if a politician thinks we might see hyperinflation? He will do everything in his power to slow down the money supply growth. Great! The more the merrier!! Heck, rid us of all paper money if you could … all it would do it accelerate our direly needed return to an honest, free money.

    Granted, I would not want to have him as my financial advisor. But that doesn’t diminish his qualities as a fighter for more freedom and smaller government.

    Regarding the Yuan, it looks like more people are beginning to catch on to what I have been suggesting since July. Maybe I wasn’t paying attention back then, but it seems like there’s quite a few more bloggers among the Dollar bulls now than there were then. :)

    I with you a Happy Thanksgiving, too, and thanks for the continued interest and all the suggestions.

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