Thursday, September 14, 2006

China's Pegging - Mercantilism Plus

China's Pegging: Be Careful What You Wish For
by Sybil Star

Certain countries peg their currency to the dollar, most notably in Asia and in the Middle East. The measure has short-term advantages for the peggor and/or the peggee. Some peggors peg to avoid reevaluation upward of their currency, as this allows them to sell their exports at an artificially maintained low dollar price, guaranteeing export sales growth for the near future. In this instance, the peggee is also a short-term winner, getting to continue buying those products at that low price, for the near future.

The problem is twofold. First, the dollars accumulate in the pegging nation's coffers, because to sell them back to the exchange marketplace would lower the dollar's exchange rate and put pressure on the peg. So pegging central banks either use them to buy American goods or American assets, like treasury bonds, stocks, securities or real estate, and they just store some of them in their reserve accounts to use as backing for their own monetary unit, just as banks used to do with gold in the good old days.

This is all fine and good for a while, and some peggors see this as a golden opportunity. But there is a limit to how many dollars they can dispose of and store in this way. At some point, something's gotta give, because they're gonna have either internal inflation themselves, or if they limit money creation, they'll end up with a huge foreign exchange account full of dollars and American assets whose exchange price may not always be the same if things were to reverse all of a sudden, as has happened with past peg scenarios.

But there is another ramification of not selling the dollars in the exchange market and thereby not allowing the dollar to find its natural level. When the dollar sinks relative to its trading partners, American exports become less expensive, i.e. more competitive on the international marketplace. However, if the peggors prevent it from sinking or slow the sinking down, American manufacturing prices remain relatively high on the international market. This hurts American manufacturers and their employees, and puts pressure on salaries in general. The CPI remains low and the Fed loosens money, making more dollars for the Chinese to store (and devaluing the real value of the dollar in the process, albeit imperceptibly at first.) It also makes America's trade imbalance grow, which it has recently done to a record $68 billion in July.

The Chinese and a few others have been pegging their monetary unit to the dollar for some time now. In July of 2005, someone managed to persuade China to begin letting it slide, and they have allowed the yuan to rise a total of about 4% since then. It still has a long way to go to represent reality, so Congress is getting impatient.

As described in this article at Breitbart:

"The administration is pushing China to move more quickly to allow its currency to rise in value against the dollar as a way to narrow the yawning trade gap by making American exports cheaper in China and Chinese goods more expensive for U.S. consumers. Congressional critics of China's trade policies have warned that if China does not act, they plan to push for a Senate vote before the end of this month on legislation that would impose 27.5 percent penalty tariffs on all Chinese imports. That would drive up the price American consumers would have to pay for Chinese clothes, toys and consumer electronic products, but supporters of the legislation contend a strong U.S. response is needed to force China to stop manipulating its currency to gain unfair trade advantages."

But either way, we have a problem. If Congress puts the tariff in place, American CPI would shoot upward, with the increase in prices of imports from China. But if China were to let its yuan go and reevalue upwards, American CPI would also shoot upward with the increase in prices of imports from China.

Can't win for losin'. And Goodness knows what the Fed would do then. They'd be forced to tighten, but at the wrong time from a business cycle point of view. And yet something's gotta give here. And it will give, either through the door or through the window, as they say in France.