Currency Wars: The Chinese View

Let’s be fair: the Chinese have a point.

They can rightly claim that the US is trying to inflate the world economy by flooding it with dollars, and that the flood is about to reach tsunami proportions if the Federal Reserve Board goes ahead with its long awaited second round of “quantitative easing”, or QE2 as it has become known as colloquially.The problem is that we face two separate yet intertwined requirements in order to get the global economy back onto solid ground.

First we need those countries running trade surpluses to switch to a policy based more on domestic demand in order to absorb the excess savings that they are throwing off. Those excess savings are a result of their focus on production and export rather than on consumption. During the last decade this wave of excess savings sloshed around the world economy and was absorbed only by the creation of asset price bubbles in the importing countries like the US and the UK. The world suffers from a lack of aggregate demand, and while the US, UK, and others cut their debt levels they cannot be relied upon to provide that demand. Someone else must. That would be China, Japan, and Germany principally.

Second we need the importing countries to go in the opposite direction and reduce imports by switching either to lower consumption levels permanently, or by increasing their production and export of goods and services. The US plays the pivotal role in this switch since it is the world’s largest economy and has the world’s largest imbalances.In broad terms what we need to do is to ditch the Reagan illusion and reduce debt while at the same time increasing our focus on basic economic activity in areas such as infrastructure and production. We need to make or build actual stuff rather than play at bankers all the time. It turns out we weren’t very good at banking anyway, but that’ another story.

The problem is that this switch is not easy. We are still deeply mired in a period of debt reduction. That means that the US private sector – households and businesses – is retrenching rather than expanding. This opens the door for a perilous disinflation or, even worse, deflation. We should all expect the Fed to react strongly to any news that the pace of inflation has dropped too low. My own view is that we could do with a solid bout of inflation in order to relieve the stress on debtors and thus make the adjustment to a lower debt regime more comfortable.

Just to make things difficult the likely course of monetary policy is that the Fed will try to lower long term interest rates through QE2, maybe starting this month, but at the same time signal its desire to allow inflation to creep up. In normal circumstances these two movements would be going in opposite directions. Rising inflation should be priced into interest rates by an increase in the “inflation premium” they include. Rates would thus rise, especially at the longer end of the yield curve. But: aggressive QE2 actions would flood the economy with even more liquidity and drive rates down, especially if the Fed announces its intention to keep rates low for an extended period. My bet is that the Fed is looking to get the long term bond yield down to 2.0% and keep it there. If it succeeds there is precious little room for an inflation premium. Do the math: if we expect inflation to edge above the top of the Fed’s target range, which the Fed would dearly love to see happen, then the presumed inflation premium would be bid up to reflect that expectation. Deduct that premium – let’s say it’s 3.0% – from the newly reduced long term rate of 2.0% and we disclose a negative inflation adjusted rate of 1.0%. Lenders would be paying you to borrow, instead of the other way round.

If that doesn’t encourage borrowing I don’t know what will. Which, of course, is the entire reason for QE2.

And this is where the Chinese come in.

QE2 is a massive purchase operation by the Fed. It will enter the money markets and buy up securities. The cash it uses for the purchases will flood the coffers of those selling and, more than likely, they will be tempted to buy new securities or other assets rather than hold onto the cash. As they search for new places to invest they will naturally look for higher returns than those offered in the US, especially as the whole point of QE2 is to lower those returns. So some of the cash, indeed a good percentage, will find its way into foreign markets. Their are two types of such markets: those with high rates of return due to their fast growth – these are typically emerging economies like China, Brazil, and India – and those with lower rates of growth, but less perceptible internal imbalances like Switzerland. This inflow of American sourced cash will tend to drive up asset prices and, or, drive up the exchange rates of those countries. In effect the US is trying to inflate the global rather than face deflation domestically. This is a disruptive policy and flies in the face of what is sensible for those nations affected.

So a battle royal could erupt.

The Chinese would dearly like the US to go through depression as it strips away the Reagan illusion. The US would dearly like the Chinese to accelerate demand rather than stifle it by focusing on exports.

The Chinese have a point. We are forcing the consequences of our thirty years of stupidity on the world rather than taking the medicine we have so often foisted on weaker countries abroad. Thinking back through the Reagan illusion we can identify plenty of occasions when the US forced countries to go through enormous, and often rapid, adjustments. Those adjustments were painful, austere, and deflationary. Exactly what we are now seeking to avoid.

Unfair?

Absolutely.

Likely?

Absolutely.

The US has a great advantage in that the dollar is still, although maybe not for much longer, the world’s currency. The Chinese and others have to be mindful that if they resist their options are limited. The main one being to offset the flood of dollars by buying them up and stashing them in their central bank reserves. That would reduce the impact on their currencies, but would imply a huge run up in dollar based debts that they own. And the ownership of all those dollars gives them a stake in the success of the Fed’s attempted inflation.

So they are damned if they do, and damned if they don’t.

As a result: look for a very tense round of negotiations during November leading up to the Group of 20 meetings in South Korea. If those meetings fail to outline a more cooperative way out of the current global imbalance, the likelihood of a round of hostile policy moves, including tariffs, competitive devaluations, and even capital flow restrictions shoots up.

There is a whiff of war in the air. Currency and trade war.