China's Dollar-Commodity Vise   (October 22, 2010)

Despite an outpouring of opinion about revaluing the Chinese yuan, very few (if any) commentators describe the vise China is in as a result of pegging the yuan to the dollar.

If there is any topic which generates more spin and less insight than China's currency, the renminbi (yuan), it has escaped my attention. It is remarkable how opinions magically gain credibility by being unskeptically repeated ad nauseum.

If we scrape away the spin, we find that China is not in charge (as many seem to think, or want to think) of the dynamics, but rather it is trapped between the jaws of an inescapable vise in pegging its currency to the U.S. dollar.

If the USD continues plummeting against other currencies, then China will be paying more for the commodities it needs to fuel its economy. Oil is priced in dollars. Even if it is priced in yuan, what difference does it make? None, because the yuan is pegged to the dollar. One dollar and 6.8 yuan buy the same quantity of oil because of the peg. The Chinese can "inoculate" their dollars by issuing yuan in trade for domestically held dollars, but they still can only buy as much oil as the dollar bought.

Trading their yuan for yen or euros still buys them the exact same quantity of oil (minus the exchange commission costs).

That's the downside of pegging to the dollar: the yuan is merely a proxy for the dollar.

The lower the dollar sinks, the more commodities will cost in China--not a good thing for an economy that is heavily dependent on inefficient production and a real estate bubble for its growth.

The only way to decouple the value of the dollar from commodities would be to have two different valuations for the yuan: one for physical-goods commodity trade and one for currency trades. Short of that dual-currency system, China will be forced to swallow massive inflation in commodity prices as the dollar weakens. That inflation threatens its citizens with declining purchasing power and its industries with much higher costs.

The other side of the vise is a much stronger dollar. Were the USD to strengthen against other currencies, then China's export goods would cost substantially more in Europe and Japan--in effect, making Chinese goods less competitive everywhere except the U.S.

If the dollar weakens, China will import inflation and much higher commodity prices, hurting its economy.

If the dollar strengthens, then Chinese goods become much more expensive when priced in Euros, yen, etc. Either way, China's economy suffers negative consequences.

Is being trapped in a vise controlled by another State really being in charge? Who would choose to give the power over commodity prices and one's export prices to another nation? That is not power, that is weakness. the U.S. can do whatever it wants with the USD, and the Chinese will take the consequences. "Inoculating" the surplus dollars piling up in China and adjusting the peg are merely tweaking the side bets in a game owned and controlled by the U.S.

Everything else is bluster for domestic and international consumption.

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