China’s currency play and world markets

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Dear Investor

China has defended its currency for long to remain largest world exporter. Undervalued currency offered many advantages to China like cheap labour force for multinationals and local majors, suppressed wages also kept inflation low and thus higher wages in check and thus China remained largest and cheapest exporter of world.

But, that is changing now. China is allowing Yuan to rise faster than expected earlier. China is also opening Yuan denominated market. China has also entered into agreement wherein its emerging nations trade partners will now be using Yuan to trade with china. Earlier it had to buy dollars first and then to buy Yuan using dollars. China has eliminated that middle role of dollar with small to medium sized trade partners. China has also expanded Yuan’s daily trading range to 1% allowing better breadth and depth. China also started selling Yuan denominated bonds from Hongkong last year.

In short, China has taken all primary steps to ensure that Yuan can be launched worldwide like Dollar and Euro.

Importance of currency can also be understood from Eurozone formation 10 years ago. European nations formed union to launch currency alternative of dollar and benefits are many.

US borrows money from entire world at cheap rate to feed its giant debt addict economy. Being reserve currency, every nation has to pass through that gate.

China has awakened. Chinese leadership preparing Chinese population for slower growth and higher consumption. It has been said since many years that Chinese economic model is based on exports and that was true until 2008.

Post 2008 crisis, China realised that it has to balance the trade, for that consumption needs to be increased. To increase consumption, it needs to increase wages and should free some of the key consumption markets. Wages have doubled since then in China.

When wages are increased, inflation is bound to follow eating away wage increases. Solution is appreciate currency and allow more imports. That is what US has been doing since years. US consumers could enjoy heavenly life because US was world’s reserve currency and being most valued currency it could buy everything cheap from rest of the world and hence industries excluding technology and research either vanished in US or was shifted to China. That is how you can increase consumption keeping inflation in check.

China has understood the model and now ready to implement with adequate caution.

In next few years, Chinese Yuan would be must be currency in treasury of every Government.

That leads to next question,, Yuan would appreciate against what? Yuan would appreciate most against dollar. That is for sure.

That leads to another question, will US allow China to appreciate against dollar?

We all know, Obama, Geithner and Bernanke have been awaiting for that auspicious day since long….. time.

Because if appreciated Yuan is solution for China than devalued dollar is much deliberated solution for US.

Because China does not want inflation and US wants inflation. China wants to contain the asset prices to stem the inflation. US wants to raise the asset prices to come out of the crisis.

Yes, inflation would not remain limited to asset prices in US and will definitely spread to food and non food manufacturing items but path goes that way out only.

Why?

Crisis started in US because of Housing market crash. Home valued dropped 30-40% and that led to mark to market losses to banks and banks were on the brink of bankruptcy. Fed intervened and bailed them out. But, home prices in US are still 40 to 60% down depending geographical areas. Banks are still under the water.

Fed did everything in its power to prop up the housing prices so that banks can come out clean of it and US economy can be put back on the pre crisis level. But, policy did not pay intended results, instead it increased energy and food prices and everything US imports because US dollar went down against all major economies of the world.

Meanwhile, US has accumulated gargantuan debt in bailing out banks and thrifts. Now, US borrows more than half of every dollar from foreigners to run the nation. US knows that it can’t pay debt at face value.

There are 2 options. 1. To declare bankruptcy and 2. To pay down the debt with much cheaper dollars.

US has already printed too much too cheapen the dollar and now US citizens are protesting against the policy of currency devaluation. Because that has led to higher food and energy prices. To continue the currency devaluation policy, US needs someone to blame.

Same way, China cannot say its exporters to stop the business because in larger interest it has to allow Yuan to go up. But, to continue this policy, China, too, need someone to blame.

But, US and China can take the intended steps putting blame on each other.

Like, US has been blaming China as currency manipulator and asking China to allow more appreciation of Yuan. But, the message behind the statement is we want to devalue dollar, you are our largest debt holders, you can help us to depreciate dollar more.

So, this is complimentary action for both the nations. Obama had sought G2 after crisis to facilitate this arrangement.

Hence, be ready for this action, world would look much different when China will become third polar in currency market after dollar and euro.

I will write about its implications later.

Best Efforts…..

Dhaval Shah

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