When Will China Revalue the Yuan?

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traders have to live with this question continually. He who is
on the wrong side of that trade will get hammered, the way that
those who were short the dollar and long the peso got hammered
when the Mexican government floated the peso in the summer of
1976. I can remember one hard-money investment advisor who had
touted investing in pesos in early 1976, because you could make
a safe, guaranteed 200% per annum on your money. I also remember
his "Sell!" notice, sent by first class mail, mailed
a day after his clients lost up to $35,000 per futures contract.
Too late, of course, as he knew when he sent it.

The Chinese
central bank’s floating of the yuan — or more likely, controlled
("dirty") floating — will have repercussions on us when
we shop at Wal-Mart or other retail outlets that sell Chinese-made
products. These products will get more expensive, assuming the
yuan moves up, which all commentators assume, including me.

The question
is: How soon?


Fixed currency
exchange rates are price controls. But, unlike most price controls,
fixed rates are controls on products produced by government-licensed
monopolies: central banks and commercial banks.

Price controls
produce gluts of those products whose prices are set above the
free market price, i.e., price floors. Price controls produce
shortages of products whose prices are set below the free market
price, i.e., price ceilings.

A price control
on currencies is simultaneously a price floor (the overpriced
currency) and a price ceiling (the underpriced currency).

The Chinese
central bank, operating at the discretion of the Chinese government,
has established a price ceiling for the yuan and a price floor
for the United States dollar: 8.3 to one. This has produced heavy
demand for the yuan in terms of the dollar.

To avoid
a shortage of yuan — "Sorry, no yuan for sale at the official
price" — the Bank of China keeps expanding the monetary base.
It creates yuan, and then uses some of the newly created yuan
to purchase dollars in the open market, with which it then purchases
U.S. Treasury debt.

The alternatives
to this policy are these: (1) float the yuan — i.e., abolish the
price controls — which will raise its price in terms of dollars;
or (2) allocate access to yuan on a basis other than open market
purchase. In other words, either "high bid wins" or
"stand in line." Currencies are like other scarce commodities.
They are allocated either by price or by favoritism, i.e., "Get
to the front of the line by doing things my way."

There was
a time, prior to August 15, 1971, the day Nixon

  1. unilaterally
    told the Treasury to stop selling gold,
  2. floated
    the dollar, and
  3. imposed
    price ceilings on everything except raw agricultural products,
    when conservatives argued for fixed exchange rates "to
    stabilize the currency markets and reduce risk." In other
    words, they argued for price controls on currencies, even though
    they also argued for free market pricing on all other items
    offered for sale. Today, there are few economists outside of
    China’s central bank who call for fixed exchange rates. They
    have learned their lesson. The free market works. It lets buyers
    and sellers set prices, thereby avoiding gluts and shortages.

Fixed exchange
rates never did stabilize the currency markets. They stabilized
the official price of currencies in relation to each other, but
always created gluts and shortages in the currency markets. Then,
from time to time, a central bank would devalue its currency in
an overnight change of policy, which inflicted huge losses on
currency traders on one side of the transaction and huge profits
for those on the other side. It was official price stability for
a while, and then instability on a massive scale without much
warning, other than official assurances that the change was not
being contemplated.

I remember
Treasury Secretary John Connally’s press conference on Monday,
August 16. He was asked by some reporter why he had assured everyone
that the government was not contemplating such a policy. He gave
an honest answer. If he had told the truth, he said, the run on
the dollar by foreign central banks to buy gold from the Treasury
at $35/oz would have been even greater.

The Dow rose
almost 33 points that day — a huge increase in those days.

The Chamber
of Commerce and the National Association of Manufacturers issued
positive press releases. No more inflation!

Within a
year, shortages were everywhere: the inevitable effect of price
and wage controls. There had been a gasoline war going on that
weekend in California. I can remember prices at 21 cents a gallon.
Normally, prices were around 30 cents. Gas stations ran out of
gas and then went out of business. But it was great for 7-11 franchises.
That was the era in which gas stations set up convenience stores.

Nixon’s price/wage
control program was abandoned in late April, 1974, after it had
disrupted American markets. The system had never been enforced
vigorously or else the disruptions would have been worse. Nixon
resigned in August.

gold sales were never restored. In January, 1980, gold was selling
for over $800/oz — briefly.

The dollar
was permanently floated in December, 1973, although the float
has been "dirty" for much of the time: some central
bank intervention by one or another central bank. Today, only
China enforces a fixed rate.


From time
to time, I read about "exported deflation" into the
United States and "exported inflation" from the United
States. A
recent example of this line of reasoning appeared in The Asia
The author wrote:

hegemony emerged after 1971 from the peculiar phenomenon of
a fiat dollar not backed by gold or any other species of value,
continuing to assume the status of the world’s main reserve
currency because of the US’s geopolitical supremacy.

This is nonsense.
Dollar hegemony emerged after 1945 because the United States was
the world’s strongest economy. The Bretton Woods international
monetary agreement of 1944 assured dollar hegemony. When Nixon
broke the terms of Bretton Woods by closing the gold window, he
did not undermine dollar hegemony. There was no other central
bank/nation willing to re-establish gold convertibility. So, the
dollar has won by default.

Such currency
hegemony has become a key dysfunctionality in the international
finance architecture driving the unregulated global financial
markets in the past two decades.

This is true
enough, but without the cooperation of other national governments
and central banks, this hegemony could not be maintained. The
hegemon is not in a position to force other central banks from
re-establishing the gold standard.

This may
be overstated. Because most countries store their gold in the
vault of the Federal Reserve Bank of New York, there may be some
pressure: a threat by Washington to confiscate a nation’s gold.
If this threat has been made, it has been made very quietly. If
the U.S. ever did this, foreign nations could torpedo the dollar
by selling T-bills
in one retaliatory move. Tit for tat is
a well-respected policy internationally.


Our author

overheated economy is the result of hot money inflow caused
by dollar hegemony.

This is nonsense.
The Federal Reserve System has no authority in China. The FED
has been increasing the U.S. adjusted monetary base at a mid-single-digit
rate. The Bank of China has been increasing its money supply at
rates much higher. The hot-money inflow of dollars into China
has to do exclusively with China’s policy of making available
cheap money at a fixed rate. The old economic rule holds up: "At
a low price, more is demanded." The Chinese central bank
is subsidizing the creation of demand for its own currency by
fixing the rate below the market. Then, in order to meet world
demand of yuan in dollars, it creates fiat money. To blame the
FED is ridiculous. Blame the Bank of China.

By the way,
"dollars" do not "flow into" China. They move
from some accounts in large multinational banks into other accounts.
Jones buys yuan with dollars and transfers this money to Wong,
whose account rises. Jones bought yuan from Chen, who may buy
T-bills. Or, more likely these days, Jones bought yuan from the
Bank of China, which now buys T-bills.

While paper
dollars do circulate in third-world nations whose nationals have
moved to the U.S. and mail home dollars, the number of paper dollars
in China is minimal, as far as anyone knows. If they do circulate,
they came from Chinese residents in the U.S. who sent money home
to their families. Federal Reserve Notes do not circulate in China’s
capital markets.

developing economy should be able to absorb huge amounts of
capital inflow, but dollar hegemony limits foreign investment
to only the Chinese export sector, where dollar revenue can
be earned to repay capital denominated in dollars. Since China’s
export sector cannot grow faster than the import demands of
other nations, excessive dollar capital inflow overheats the
export and exported-related sectors, while other sectors of
the Chinese economy suffer acute capital shortage.

This is also
nonsense. Dollar hegemony has nothing to do with which sector
of the Chinese economy is favored by investors. Investors with
dollars in their bank accounts are buying yuan in order to get
in on China’s economic boom, which is being sustained by the Chinese
central bank’s policy of monetary inflation. China’s economy is
a bubble economy. Investors are willing to buy in to any sector
where they can find Chinese "cousins" to expedite deals.

economies produce growth-inhibiting inflation through excessive
import of money and sudden rises in prices for imported commodities
and energy.

He has it
exactly backward. Central bank inflation of a nation’s currency
is what creates an overheated domestic economy. Central bank inflation
can also create a boom in a foreign nation’s economy. How? By
lowering foreign interest rates. How? By purchasing that nation’s
treasury debt. This is taking place in the United States today.
It is the inflow of capital from the Bank of China that is subsidizing
the U.S. boom, not the other way around. China is running a $100
billion trade surplus with the United States. It is buying U.S.
assets, mainly T-bills, with this excess $100 billion.

It is not
the excessive import of foreign capital that causes economic overheating
in China. It is the boom created by monetary inflation, coupled
with China’s fixed exchange rate policy, that sucks in foreign
investment capital. Investors love to invest in bubbles.

The imported
inflation is then re-exported, causing inflation in other parts
of the global economy.

This man
does not understand economic cause and effect. Imported inflation
is not re-exported. What is exported are cheap products made in
China. While it is wrong to speak of "exported deflation,"
because deflation is accurately defined as "a decrease in
the money supply," it is legitimate to speak of price competition.
China is surely price competitive. Capital flowing into China
makes Chinese producers even more productive. Prices fall, or
else fail to rise as rapidly as they otherwise would have, in
nations that import Chinese-made products.

causes interest rates to rise, which in turn causes unemployment
and recession in all economies that are plagued by it.

But China
is price competitive. It is pressuring consumer goods prices in
foreign nations to fall. This causes interest rates to fall: a
lower rate for the price inflation premium that is built into
in long-term loans by lenders who demand compensation for the
threat of depreciating money.

Add to this
factor the demand for U.S. T-bills by the Chinese central bank.
It causes American short-term rates to fall. Rising demand for
T-bills from China lowers the rate of interest because the Treasury
can sell T-bills at a lower price. It is China’s central bank,
not the FED, that is the main source on the supply side for today’s
low interest rates in the United States.

hegemony enables the US to be the only exception from macroeconomic
penalties of unsynchronized exchange rates and interest rates.
The US, because of dollar hegemony, is the only country that
can claim that a strong currency that leads to trade deficits
is in its national interest in a global economy dominated by
international trade. This is because a strong dollar backed
by high interest rates helps produce a US capital account surplus
to finance its trade deficit.

High interest
rates? In the United States? Have you checked your rate of return
from your passbook savings account or money market fund? What
has this guy been smoking?

Having misunderstood
economics, and having perceived low interest rates in the U.S.
as high interest rates — i.e., imposing bad economic theory on existing
economic facts — the author then does something remarkable. He draws
a correct conclusion.

The issue
is not whether Asian central banks will continue to have confidence
in the dollar, but why Asian central banks should see their
mandate as supporting the continuous expansion of the dollar
economy at the expense of their own non-dollar economies. Why
should Asian economies send real wealth in the form of goods
to the US for foreign paper instead of selling their goods in
their own economy? Without dollar hegemony, Asian economies
can finance their own economic development with sovereign credit
in their own currencies and not be addicted to export for fiat
dollars. As for Americans, is it a good deal to exchange your
job for lower prices at Wal-Mart?

There is
one answer to all of these questions: mercantilism.


Asian politicians
are the victims of a false economic theory that was refuted by
Adam Smith in 1776. They have been hypnotized by the success of
the post-war Asian tigers in building their economies through
exports to the West, especially the United States. That legendary
success was based mainly on the increased productivity of Asian
industry through the creation of domestic capitalist markets.

Yet, even
here, there was a mercantilist element. Asian exporters were governed
by domestic government bureaucracies. Only certain products were
allowed to be exported. The most well known of these bureaucracies
is Japan’s MITI: the Ministry of International Trade & Industry.

Like mercantilists
in the seventeenth century, today’s mercantilists draw a false
conclusion. Instead of working to reduce the control of government
over the domestic economy, especially central bank control, Asian
politicians conclude that government control is the basis of the
success of the export sector. Also like seventeenth-century mercantilism,
the political benefit from catering to a minority sector of the
economy — exports — is high. Exporters know where their bread is buttered:
in Parliament. They and the politicians can justify Parliament’s
splendid pay-off — pressuring the central bank to lower the international
value of the currency by inflating it — by arguing that "exports
are good for the economy."

The hegemony
of the dollar is indeed one factor in the Asian governments’ willingness
to subsidize exports to the U.S. OPEC governments that control
the export of oil — socialist ownership — demand payments in dollars.
This is an American payoff to Middle Eastern sheiks for promised
support against domestic revolution: American-made weapons and
training. This is the hegemon in action.

the main reason for Asian governments’ policy of subsidizing American
consumers through currency depreciation is domestic mercantilism.
There is a sweetheart deal among Asian exporters, politicians,
bureaucrats, and central bankers. We Americans are the beneficiaries
at the expense of Asian consumers.

Grab it while
you can. The gravy train won’t last forever.


There is
no question that the Chinese economy is overheated.

This is the
exclusive fault of the Bank of China.

The central
bank’s policy of monetary inflation has created the boom phase
of what Austrian School economists describe as the boom-bust cycle.
Austrian economists blame central bank inflation for booms and
busts. In this sense, Austrian economists are unique. Their view
is not popular.

China has
a tiger by the tail, to quote the title of a 1972 collection of
articles written by Austrian economist F. A. Hayek. China’s central
bank has created the boom phase of the economy. If it does not
cease inflating, there will be a crack-up boom, as Ludwig von
Mises called it: the destruction of China’s currency in mass inflation.
On the other hand, if the bank slows the rate of monetary inflation,
there will be a recession or worse. The bubble will pop.


causes and effects are not racial. They are not national. They
operate in China, just as they operate everywhere else. The Bank
of China has created a boom that is as artificial as the yuan’s
fixed exchange rate with the dollar. This boom cannot be sustained
without negative consequences. It also cannot be ended without
negative consequences.

dominates China. The Communist Party of China is no longer Marxist
in economic theory, but it surely is Leninist in political power.
These aging leaders are not going to risk losing their power by
calling a halt to the boom — not unless domestic inflation escalates.
The pain of such economic pressures on politicians will determine
the timing of any change in Chinese monetary policy.

the political pressure of unemployed workers in huge cities where
jobs have disappeared. This pressure is very different from, and
more excruciating than, recessionary pressures on self-sufficient
family farms in distant rural regions. We are watching 200 million
people streaming into Chinese cities in one decade. There has
never been a population move like this one. These uprooted newcomers
are now concentrated in tight geographical areas. Take away their
jobs and their dreams overnight, and you have a truly revolutionary
situation on your hands. What’s a little price inflation compared
to this? What’s a whole lot of price inflation compared to this?

Terry Easton
thinks that the Chinese government will keep fixed exchange rates
until after the 2008 Olympics, which will be held in Beijing.
That’s as good a political guess as any. Of course, serious economic
pressures can surface before then.

Saving face
is higher on most Asians’ value scales than saving money. Capitalism
is a new import there. The fear of shame is deep-rooted. Chinese
society is a shame society. This will add political pressure to
maintain the fixed rate. China wants lots of visitors, and keeping
the yuan low will encourage these visitors to come. Urban discontent
in the streets is not favorable to foreign tourism.

But there
are other considerations. China is now running a small trade deficit
with most of the world, even including the $100 billion trade
surplus with the United States. Capital is flowing into China,
and not just dollar-denominated capital. If domestic prices start
rising rapidly, exports will be reduced. There will be pressure
on the Bank of China to slow the rate of monetary inflation. If
the central bankers have not read Austrian School economics — this
seems likely — they may not understand the size of the tiger they
have by the tail or how fast he can turn. The bankers may risk
a slowdown, not expecting a depression.


The political
prestige of the Olympic games is high. China’s rulers want to
share in the glory of the games, which will mark China’s entry
into the world’s ruling nations. But four years of price inflation
can add up. So can shortages of price-controlled items, such as
water and electricity, which are already being rationed politically.

power is not democratic in China. The power elite in China is
in a strong position to pursue bad monetary policy. I do not think
most Westerners understand China’s political rulers and the pressures
they feel.

I think Chinese
politicians understand power better than American politicians
do. Power has been a life-and-death matter in Communist nations.
These men grew up during Mao’s cultural revolution. They survived.

An American
retreat from Iraq will motivate China’s rulers to abandon the
dollar if they think there will be a switch to the euro or other
currencies by OPEC. It is not losing face to abandon a sinking

Let us not
be nave. China’s politicians set central bank policy. The political
dog wags the central bank tail in China, unlike in the United

expect an end to fixed rates in China within a year after the
United States pulls out of Iraq. If U.S. troops are still there
in 2008, then I would expect floating rates before 2009. But I
don’t think we will have to wait that long.

28, 2004

North [send him mail]
is the author of Mises
on Money
. Visit http://www.freebooks.com.

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