Certain rumblings among Chinese officials suggested that the authority might be allowing Chinese Yuan to appreciate at a faster pace because exchange rate might be a tool for them to slow inflation. While it is probably a change of thinking, I wonder if that will actually happen.
There are good reasons why China should allow Yuan a.k.a. renminbi to float freely (I mean float freely, literally. Not faster appreciation). Currency peg is pro-cyclical, which is exactly the problem faced by China right now. Strong demand for Chinese goods means strong demand for Yuan. In order to keep the exchange rate low amid strong demand, they have no choice but to increase supply (i.e. money supply) and accumulate foreign exchange reserve a.k.a. buying US Treasuries. That helps their exporters and economy, but that brings excess liquidity, fuelling real estate bubble and over-investment of every sort.
In a free-floating currency regime, the People’s Bank of China would not have to increase money supply in order to keep the currency value low, so they can practise whatever monetary policy they wish to control inflation and real estate bubbles. Unfortunately, after years of excess liquidity, the bubbles are becoming so big that bursting of them would have nasty consequences. Those consequences will be anything but a soft-landing. China wants a soft-landing, and allowing free float at this point will probably not help.
So they prefer a gradual appreciation instead. However, I think gradual appreciation does not do much good. While both attract more demand for Yuan with the expectation of high prices in the future, there is one subtle difference. If the currency is allowed to float freely, the People’s Bank of China will not intervene in the market even though the demand for money is hot, and they do not have to increase money supply to counter that. If Yuan is allowed to appreciate gradually, however, it may attracts so much demand that create more upward pressure than the central bank would like to see. In that case, the PBOC may have to increase money supply, which is exactly the opposite to what they want to do.
A one-off appreciation makes some sense if it is large enough, and if the government communicates clearly that the Yuan will not be allowed to appreciate for an extended period of time (very Bernankesque). It would, hopefully, create an expectation among investors that the Chinese Yuan will stay at the new price for some time until further notice, preventing more capital in-flow (which they so much fear). A large one-off appreciation will probably also help the Chinese to at least stop further accumulation of foreign exchange reserve (at least for a while). Of course, too large an appreciation will risk a hard-landing, and that is the reason why it is unlikely (you see, none of the solutions is perfect).
If a one-off appreciation does happen, however, there are big two consequences. First of all, the Chinese economy might be slowed down quickly. Second, as the foreign exchange reserve accumulation will be halted (or at least slowed down), demand for US treasuries from China will drop. And because US dollar will depreciate against Yuan, Americans will finally see some true inflation (before they change and buy stuff from even cheaper countries).
Ben Bernanke desperately wants to see inflation. So there you have it, and the era of cheap money will be gone. Expect exit strategy sooner.
This article originally appeared here: The Case For One-Off Appreciation, Or They Want To Get Rid Of US Treasuries
Also sprach Analyst – World & China Economy, Global Finance, Real Estate
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