Tough love with China

I am not sure if conventional wisdom of asking RMB to strengthen will be benefit the US economy still holds or not. The thought that simply see the peg as China’s principal weapon in an economic struggle for global ascendancy is both incomplete and naïve. The argument that if China were to allow its currency to rise, American manufactures would regain their lost edge and both manufacturing firms and the jobs formerly associated with them would return. However, it tells the wrong story, in my view.

My point is that the abandonment of the RMB would cause severe hardship in the US. The US economy is currently on life support provided by an endless flow of debt financing from China. These purchases are the means by which China maintains the relative value of its currency against the dollar.

When China drops the peg, the immediate benefits will flow the Chinese, not the Americans. Yes, prices for Chinese goods will rise in the US – but so will prices for domestic goods. As a corollary, the Chinese will see falling prices across the board. In addition, credit will expand in china while it contracts in the US. When the RMB appreciating, it no longer needs to sell its currency reserves by buying Treasuries, then prices and interest rates in the US will rise. Americans will lose access to the consumer credit that funds their current spending, but the things they buy will also get more expensive.

The People’s Bank of China stated that it will fine-tune the exchange rate formation mechanism in connection to capital flows and the movements of major currencies. This is the first official hint that China will take global exchange rates as a benchmark for the RMB exchange rate – is a very subtle but very important change in China’s exchange rate policy. The change in short-term currency movement may not be big but this is a significant shift away from the current set up.

When domestic demand counts for a larger weight in the Chinese economy, enhancing purchasing power would outweigh the objective of maintaining export competitiveness. The recent change in thinking that happened to the Japanese Yen could happen to the RMB as well. In short, we just saw a construction step towards that direction – albeit a small step for now.