The Bankwatch

Tracking the consumer evolution of financial services

China looks at severing dollar peg | and why this will be the biggest economic story of 2010

This is one of those nondescript headlines that is probably the single most important one following the 2007 economic crisis.  It sets the stage for (obviously) currency shifts and (less obviously) price pressures in the west.  Those countries that import from China will pay more for those imports, and therefore will suffer currency and interest rate pressures.

Beijing looks at severing dollar peg | ft.com

China’s central bank chief laid the groundwork for an appreciation of the renminbi at the weekend when he described the current dollar peg as temporary, striking a more emollient tone after months of tough opposition in Beijing to a shift in exchange rate policy.

Why is this happening?  China is in a bubble economy right now, with real estate prices exploding to 2005 Manhattan levels.  Government spending is at unsustainable levels following attempts to replace reduced exports.  This in a country that is largely third world is not going to fly, and is causing unsustainable social pressures between urban and non-urban areas.

For a good explanation of how China has accomplished this Kimberley explains:

China has fixed the value of its currency, the yuan, to the dollar. Currently, a dollar is worth 6.8 yuan. Many analysts think it is artificially low. If China allowed its currency to float freely, it would be more valuable than the dollar because of China’s strong economy, and it would rise. China does this to keep its products cheaper than U.S. products, thus increasing its exports to the U.S.

The only way China can keep the yuan artificially low is to promise to redeem dollars for yuan at the fixed rate. To do so, it must keep a good supply of dollars in reserve. Instead of holding dollar bills, it holds U.S. Treasuries, which it can quickly sell for dollars. As China’s economy grows, it must buy more and more U.S. currency to meet the growing number of yuan.

Why do we care?  China will stop buying US currency?   Of course this is impossible, because US represents over 20% of the world economy so, US will increase the interest rates on Government securities.  It will buy more Euros and invest more domestically but the result will be higher interest rates in the west.  Higher interest rates impact everything.  Think trillion dollar debts that are mostly short term, and require to be rolled over at current rates.

Once (if) China accepts natural exchange rates this impacts retail prices,  dollar denominated government securities, cost of oil and everything that countries pay for in a relatively reduced worth US dollar.

Relevance to Bankwatch:

Rest assured this is probably the biggest economic story of 2010.  Consumers are locked into a cycle of short term rate mortgages and those will need to be renewed at higher rates.  Mr. Bank … what cushion for higher rates did you incorporate into your credit decisions when you made your loan to value ratio decision?

Written by Colin Henderson

March 7, 2010 at 16:07

Posted in Uncategorized

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