With the Paulson-Bernanke delegation heading to Beijing for the first in a series of semiannual high-level talks, the China-Dollar question is getting lots of attention. We've been discussing it over at the Gilder Telecosm Lounge -- www.gildertech.com -- and I thought I'd repost some of my thoughts contained in three items here at Disco-Tech.
posted to: Telecosm Lounge
date: 12/6/06 6:11:13 PM
Inflation, I believe, is the key variable in the economic outlook. Fed Chairman Bernanke seems to agree. Last week he gave his first big speech in four months to shake the complacency out of the bond market. He said the risks for inflation are to the upside. The problem, as Don Luskin of TrendMacro has observed, is that Bernanke is only "talking the talk, not walking the hawk."
Bernanke can say inflation is the key risk, but then why did he pause this summer? The market does not believe he will act. He can try to talk down inflation, but the liquidity build-up of the last four years is overpowering his rhetoric.
Ironically, the build-up of Chinese dollar reserves is directly tied to dollar weakness. Our Fed's own "custody holdings" are way up, as they, and the reserves of all central banks, always are during times of plentiful liquidity. Look at what happened to China's reserves during the period of substantial dollar strength from 1997-2001: reserve growth slowed way down as China sucked out reserves to hold the dollar-RMB peg.
China's reserves are a perfectly natural result of a system in which two nations engage in massive trade, but one of the nations does not yet have (1) a fully modern and sturdy financial system; (2) a convertible currency; or (3) open capital markets in which Chinese could invest abroad.
When we buy things from Chinese manufacturers or make foreign direct investments in factories or real estate there, the Chinese receipient of the dollars must turn them over to Beijing in exchange for RMB (yuan). The Chinese are in the process of making the RMB
convertible and opening their capital markets, allowing Chinese to hold foreign currencies and make investments outside China. But this is a slow process. When it happens, Beijing's dollar reserve growth will likely slow as individual Chinese citizens and companies can do more things with their dollars besides turn them over to the BoC. China is also in the process of modernizing its banking system, cleaning up lots of bad loans, and privatizing and/or shutting down the remaining SOEs (state-owned enterprises). Large dollar reserves are essential to smooth the transitions.
The U.S. hoped-for policy of a forced revaluation of the RMB is wrong-headed and futile: you cannot change the terms of trade by changing the unit of account. And by injecting currency chaos into China, this policy also would retard the much more important actions of (1) bank reform, (2) currency convertibility, and (3) opening of the capital account. These should be the key policy goals of the U.S. We want U.S. financial institutions to enter the Chinese market, and we want Chinese to be able to invest in America. The illusory goal of RMB appreciation (i.e. dollar weakening) would do nothing to strengthen the real position of American manufacturing, but it would hurt all U.S. consumers and technology companies by increasing costs. It also could lead to additional trade battles and blockages. It will marginally (or even substantially) reduce the integration of the Chinese and U.S. economies by introducing short
and long-term currency risk into all our trade and financial dealings. It also could block the aforementioned domestic Chinese reforms that ACTUALLY COULD help America.
Snapshot U.S. inflation indeces the last two months were low mostly because of comparisons to the autumn of '05 when Katrina spiked energy prices. Even so, core inflation continues to rise. Inflation indeces are notoriously long lagging. The inflation index is comprised 30% by housing rental costs. Rental costs have been supressed by super-low mortgage rates and the housing boom. Whenever rental prices rise -- there is lots of evidence they are starting
to, but low bond rates (for now) continue to push back that day -- inflation indeces will go much higher.
Nonetheless, broad inflation indeces obscure all sorts of real and real-time monetary effects happening in various markets across the globe, from energy and home prices to trade and forex flows to a temporary shift in wealth from technology and services to commodity producers. These shifts then induce do-gooders everywhere to propose specific and harmful solutions to each problem: ethanol and windmills to reduce foreign oil consumption; tariffs and currency
bludgeoning to correct trade "imbalances"; windfall profits taxes to "recapture" ill-gotten gains from high commodity prices.
The monetary pendulum is never-ending. Remember just a few years ago we had to impose steel tariffs to save the U.S. steel companies, who were struggling with record low steel prices. The losers were the auto companies and their suppliers. Now the auto companies and their
suppliers are clammoring for a weak dollar and Asian currency appreciation to relieve them from the outrageously record high costs of steel and copper wire. And to top it off, although the broad steel tariffs were repealed, "anti-dumping" duties up to 40% on corrosion-resistent steel remain in force, so steel users are paying up to 40% more on top of already record prices.
The centrality of the value of the dollar cannot be overstated. And the dollar is the responsibility of the Fed.