Real Apprecation In China, One Way or the Other

Just last week I noted that because of QE2 a real appreciation in China will occur one way or the other: either its currency will appreciate faster or its domestic prices will soar.   The former seems unlikely because of China's commitment to its export-driven growth strategy.  Consequently, China will most  likely stay tied to the Fed's QE2 monetary policy via its crawling peg and continue to allow domestic prices to soar.   I also mentioned that this real appreciation should contribute to a rebalancing of the global economy.  As if on cue, the New York Times reports the following yesterday:

HONG KONG — Inflation is starting to slow China’s mighty export machine, as buyers from Western multinational companies balk at higher prices and have cut back their planned spring shipments across the Pacific.

Markups of 20 to 50 percent on products like leather shoes and polo shirts have sent Western buyers scrambling for alternate suppliers. But from Vietnam to India, few low-wage developing countries can match China’s manufacturing might — and no country offers refuge from high global commodity prices... The trend, if continued, could ease tensions by beginning to limit America’s huge trade deficit with China.

This is an interesting article throughout, but the one thing it fails to do is connect China's high inflation to the Fed's monetary policy.  It is no coincidence that inflation is accelerating now.

Is the Chinese Yuan Significantly Undervalued?

The Economist says no:

China has been accused of “manipulating” its currency by Tim Geithner, America’s new treasury secretary, and this week Dominique Strauss-Kahn, the managing director of the IMF, said that it was “common knowledge” that the yuan was undervalued. You would assume that such strong claims were backed by solid proof, but the evidence is, in fact, mixed.

Meanwhile, Foreign Policy says that this whole discussion is moot since China's currency "manipulation" does not matter.

Is History Repeating Itself?

As we watch the dollar continue to free fall, one thing that really strikes me is how similar these recent developments are to those taking place before the break up of the Bretton Woods System in the early 1970s. Back then, the periphery countries were importing a loose, inflationary monetary policy from the dominant anchor economy, the U.S. The periphery countries also had piled up large amount of dollar reserves that eventually lost value when the system cracked in 1971-1973. Today, the dominant anchor country once again is the U.S. and is exporting a loose, inflationary policy to the periphery countries (i.e. Asia and the Gulf States) who have acquired vast dollar reserves. These countries too are now taking a huge capital loss as the dollar falls. Will this system, called by some the Bretton Wood II System, also crack like the original? Are we living through a time where economic history is repeating itself?

Part of what got me thinking about these historical patterns was the lead article and a subsequent longer piece in the Economist on the dollar's fall. These articles do a nice job explaining the structural reasons--the pressures from the huge U.S. current account deficits are finally being felt--the and cyclical reasons--the increasingly probability of U.S. recession and further rate cuts--for the falling dollar. The Economist also provides an interesting discussion of whether this decline means the U.S. dollar will lose its reserve currency status (answer: not necessarily) and what it means for the global economy. I then followed up by reading Brad Sester's discussion on these same Economist articles. He especially makes a good case that contrary to conventional wisdom, central banks can have a meaningful influence in foreign exchange markets--just look at the influence of the BRICs and the Gulf States.

What a fascinating time to be alive... as long as I keep my job!

A Picture is Worth a Thousand Words

From Kevin Kallaugher at the Economist.