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Thursday, July 21, 2005

On the Be Careful What You Wish For Front

China finally agreed to unpeg their currency. From Barry Ritholtz:
[T]oday's actions are the net result of the United States consuming far more goods or services than it produces. Because of that, the Chinese have accumulated nearly a trillion dollars of US Treasuries. That makes them a de facto player in setting our interest rate policy and impacting our economy.

The brunt of the de-pegging on the U.S. economy will not likely be felt for some time to come. But war-gaming the various scenarios of this new development, we can see that many dangers are apparent. If we play out this scenario to its logical conclusion, we are led to some unsettling possibilities:

    1) As we have been writing for quite some time now, the Real Estate Complex has been the most robust segment of the U.S. economy. If the Chinese can succeed (where the Fed failed) in raising U.S. long rates, the strongest part of the US economy is at risk. While we know real estate had to slow eventually, the question is how fast will it occur, and how dramatically.

   2) US Consumers have grown reliant on ultra low interest rates and ultra cheap Chinese goods. The de-pegging will cause incremental increases in costs, while raising rates. This will negatively impact Wal-Mart, the largest importer of Chinese manufactured products, as well as other Chinese goods resellers.

    3) Some theorists have worried about US reaction in the event of a Chinese attack on Taiwan. In an unlikely – but possible – scenario, the Chinese can, at will, and without ever firing a shot, inflict as much economic damage on the U.S. as if we were at war. Armed conflict becomes unnecessary when countries can net impact their competitors as if they were at war.

    4) The United States Dollar is the default currency of the world. That gives an unprecedented amount of flexibility to US policy makers. Is the de-pegging the beginning of the end for this global currency structure? It’s too soon to tell. But we wonder how this might play out elsewhere.

What now becomes significant is the basket of currencies to which the yuan will become ever more pegged. A likely composition will reflect a basket of currencies in proportion to China’s external trade.

According to the Bank of NY, there are 10 currencies that make up almost 90% of China’s overseas trade: the U.S., Japan, Hong Kong, EU, Indonesia, Malaysia, Singapore, South Korea, Thailand and Taiwan.

China’s top ten trade partners (in Dollars):
The European Union (18.5%)
Japan (18%)
United States (17.5%)
Hong Kong (11%)
ASEAN nations (11%)
South Korea (9.5%)
Taiwan (8.5%)
Russia (2%)
Australia (2%)
Canada (1.5%).

Source: Bank of NY
It makes some intuitive sense for the PBOC to replace their US Treasury holdings with an equivalent amount of Sovereign Treasuries of the currency basket (Hey, that’s what I would do).

The ultimate impact of today’s events will depend upon how quickly and how much the PBOC decide to sell off some of their US Treasuries. Unlike the Fed, the Chinese Central Bankers do not believe in much in the way of transparency. Their plans have been somewhat uncertain.

What is not uncertain, however, is that our Current Account Deficit has granted a degree of control and authority to another sovereign nation over our own economy. The net results of that may be determined over the coming decade . . .
The US had threatened to name China as a currency manipulator in the next Treasury Department report. And it looks like Malaysia is ready to follow China's lead. One commenter noted, "as US has become increasingly erratic and unreliable on the world stage (one-party politics, destabilizing military projection, Fortress America economics) the rest of the world will seek to immunize their systems."

Update: Krugman in the NYT: "[I]t could be the start of a process that will turn the world economy upside down - or, more accurately, right side up. That is, the free ride China has been giving America, in which the world's richest economy has been getting cheap loans from a country that is dynamic but still quite poor, may be coming to an end."