Pulling The Peg

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The following post is by Dealbreaker reader and commenter Infinite Guest.

To a nation of savers, to a growing economy, and to the general well-being of central planners, inflation poses a bigger threat than unemployment. Ahead of China’s 12th Five Year Plan, due out soon, Chinese foreign direct investment is booming; the pace of bilateral currency swap agreements quickens; China has reduced the duration of her foreign holdings; a regional currency fund using yen, yuan and won in place of dollars has been established; and there is finally a nascent foreign market for Chinese debt. Simultaneously, productivity gains are slowing, resulting in wage stagnation and growing income disparity; energy consumption is rising, pushing Chinese toward becoming a net importer; and real estate is overvalued. All of which suggests, unfortunately for the West, that the Chinese are serious about floating their currency. But first, they have to manage its revaluation.

Most fundamentals favor a stronger Yuan. A floating Yuan is another matter, however. Western experts are quick to point out that China is an autocratic technocracy whose leadership would not gladly surrender their prerogative to the whim of the capital markets. That argument ought to be mitigated by three manifest realities. First, unpegging the Yuan gives China more independence, not less. Second, China will intervene whenever it likes. Third, Hong Kong is literally in China's corner.

In both Europe and America, we tend to assume that free markets exist, that free countries exist, that the two are categorically good to have and that they work best together. From those assumptions, we have convinced ourselves to assume that alignment with the dollar is also categorically good -- well, not for Europe, and maybe not even good for Japan, but good for everyone else, at least. This despite repeated reminders throughout the developing world that a dollar peg is a de facto master-slave dialectic, in which the American business cycle is definitely not the slave. A stronger yuan, while it would directly affect the current account, does not necessarily have any impact on the balance of trade: net yuan outflows associated with China's foreign investments, replace (possibly) declining exports. A truly floating yuan, likewise, would only correct that part of China's trade surplus that is actually a monetary phenomenon. The real challenge is for China to earn a better return on its investments, denominated in yuan, than she pays on her external debt.

I doubt there is any need to elaborate on China's freedom to intervene in foreign currency markets. They already have the reserves, the domestic banking system and the relationships in place to do so at their discretion. A floating yuan doesn't change that. When other countries complain, as they inevitably will, it's worth remembering that no one has any moral high ground in the arena of currency intervention.

Hong Kong, of course, is a special case. Hong Kong is always a special case. To China, Hong Kong is a safety valve, a shield, a conduit and a laboratory. While the world's attention is fixed on the unfixing of the Yuan, the Hong Kong dollar remains within its own narrow band. A useless currency, it may yet come in handy as a tool for Beijing, if only to buffer the declining value of China's dollar-denominated holdings. Already allied with Japan, already opportunistically playing Europe against America, and increasingly well-positioned to drive a wedge between Germany and the rest of Europe, China has nothing to fear from a floating yuan. All values being relative, even the residual volatility of a (mostly) freely-traded yuan does not pose a significant threat to China's economic and social stability, but rather, to ours.