Federal Reserve Chairman Ben Bernanke may be engaged in a subtle act of economic warfare. It appears as though he is exploiting a fault in Chinese economic policy for the benefit of the United States.
A Korean economist named Ha-Joon Chang wrote a book 10 years ago titled “Kicking Away the Ladder.”
In the book, Chang lays out his theory of economic development: in order for a developing country to become a developed one, the government of the developing country must actively intervene in the economy to prop-up the export industry. This creates an industrial base from which the country can build upon. Once the export-part of the economy is sufficiently strong, the government can remove its intervention and allow the service sector to flourish and the economy to balance out.
While the Chinese may not be explicitly following Chang’s advice, they have certainly implemented his ideas.
The Chinese have a variety of measures in place to protect their domestic industries. Most of their protectionist policies concern intellectual property, according to The Telegraph.
However, the effect of the Chinese government’s policy on intellectual property pales in comparison to the effect that their policy on currency has had.
In standard monetary theory, a country’s currency may fluctuate with the country’s balance of trade. If a country is a major exporter, the currency of that country may appreciate, while countries that are major importers might see their currencies fall in value.
As China is a major exporting power, the value of China’s currency—the yuan—might be expected to rise to reflect China’s manufacturing might.
Here’s where Chang’s theory comes in: when a currency is appreciating, it might put a damper on exports. As a currency appreciates, the price of goods in foreign currencies becomes more expensive.
Essentially, if the yuan were to appreciate, the Chinese would lose their exporting-price advantage.
So, the Chinese government maintains a peg between its currency and the U.S. dollar. When the Federal Reserve creates more dollars, the Chinese create more yuan. This keeps the value of the yuan stable against the dollar, and ensures that the yuan does not fully appreciate, and thus Chinese manufacturers can maintain their advantage.
Bernanke, through multiple rounds of quantitative easing, has greatly expanded the supply of dollars in the global economy.
To maintain their peg, the People’s Bank of China has had to follow suite, printing more and more yuan to prevent if from appreciating.
Of course, as in many things in economics, the policies of the PBC have had unintended consequences.
Inflation is currently spiraling out of control in China. The Chinese CPI is up 0.20% month-to-month, and is now sitting at 5.5% on an analysed basis. Most concerning is inflation in the price of food, which is appreciating in price at an annualized basis of nearly 12%.
On Tuesday, riots broke out among migrant workers in southern China. While the official story is that the riots are over government corruption, the increasing price of food might have been a major factor for poverty-stricken migrant workers.
Ken Peng—an economist at Citigroup—warned that inflation in China may be coming from increasing wages, not commodities, according to Business Day. This may be the most dangerous type of inflation as wage price inflation might indicate that Chinese workers have raised their inflation expectations.
If Chinese workers expect higher inflation in the future, they might demand higher wages. Those higher wages then make everything more expensive, so the workers demand even higher wages, and so on. That type of inflationary spiral is unsustainable and might lead to economic collapse.
To cap inflation, the Chinese have raised reserve requirements repeatedly. Chinese banks must now maintain 21% of their deposits as reserves, which is nearly double the requirement in the United States. On June 20th, that percentage will increase to 21.5%, according to Daily Markets.
Yet, the increase in reserve requirements has thus far failed to slow the rate of inflation. The Chinese may be running out of options.
One option the Chinese have hinted at pursuing, but have thus far failed to implement, is to pull their currency peg and allow the yuan to float freely.
If the yuan floated freely, it may appreciate significantly.
Going back to their protectionism, the Chinese do not want this, as it would rob their exporters of their price advantage. It would also significantly devalue their foreign reserve holdings, of which a significant portion are in U.S. dollars.
Thus, through the process of quantitative easing, Bernanke has trapped the Chinese government.
The Chinese can maintain their peg, in which case their economy may melt down as civil unrest grows and inflation spirals out of control, or they can remove it. If they remove it, their economy might collapse as it is still largely export-led and their foreign exchange reserves would instantly be worth much less.
Either way, it is not looking good for the Chinese economy.
When Bernanke spoke last week, he reiterated his belief that commodity inflation was transitory and caused primarily by emerging market demand.
If China’s economy collapses, it would certainly reduce emerging market demand for commodities. Cheaper commodities might help the U.S. economy to recover. Perhaps Bernanke has been plotting this all along?
Bullish: Traders who believe that China will be able to slow inflation and get their economy back on track might want to consider the following trades:
- Buy iShares FTSE China 25 Index (NYSE: FXI) in a long play on the broader Chinese economy. FXI attempts to return a value corresponding to the general Chinese economy, and may rally if China continues to grow.
- Buy United States Oil Fund (NYSE: USO) in a long play on oil. The price of oil may rise if the Chinese economy continues to grow, as Chinese consumers demand more.
Bearish: Traders who believe that the Chinese economy is poised for a collapse may consider taking positions in the following:
- Wisdom Tree Dreyfus Chinese Yuan Fund (NYSE: CYB) is a long play on the Chinese currency. If the Chinese pull their dollar peg, the yuan may appreciate significantly and CYB could rally.
- PowerShares DB Crude Oil Double Short ETN (NYSE: DTO) is a short play on oil. If China’s economy collapses, global demand for oil could plummet, which may lead to a drop in the price of oil.
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.