THE REPERCUSSIONS FROM THE YUAN’S REVALUATION
July 24, 2005 –After
nearly a decade-long fixed exchange rate, it was announced
Thursday that the Chinese yuan was to be severed from its
seemingly steadfast link to the U.S. dollar. Instead, it is
to be allowed to “float” against a yet to be named
basket of currencies. These are said to include the yen, the
euro, the dollar and a number of other Asian monetary units.
Further, when the contents of the basket is set, the yuan
will be managed and the basket kept within a 3% daily trading
band. It remains to be seen how the various currencies in
this basket will be weighted, and whether this is the first
step in a series of similar yuan devaluations, or the last.
The Chinese government has been the object of an ongoing,
escalating attack for the past few years. As the world’s
various major economies have begun to stall, China has become
the global scapegoat for this condition. It has been repeatedly
charged that the Chinese have kept their currency artificially
undervalued in order to maintain an economic advantage over
its trading partners. This in turn generated greater employment
in China while simultaneously depriving workers in other lands
of their jobs. Allegedly for this reason, and in order to
curry favor from their suffering constituents, the politicians
of a number of major countries have chastised the Chinese
The yuan was first pegged to the dollar in 1994. Through a
series of modest increases it rose in value until in 1997,
it was fixed to it. The recently announced upward valuation
of the yuan was a mere 2.1% increase against the dollar. This
is a token amount that I believe was arrived upon to primarily
quiet the Chinese government’s antagonists. To my mind,
it will have little if any impact upon the balance of trade
between China and the United States. It can, however, impact
some marginal Chinese exporters who primarily supply their
products to the United States. Many of these primarily nascent
companies may find themselves out of business or approaching
the government for subsidies.
The yuan’s revaluation cheapens dollar denominated goods
and services offered in China, thereby making them more affordable
to their local consumers. Simultaneously, it makes more dear
those items that originate in China and find their way into
U.S. markets. In the end, the yuan’s revaluation will
likely be insufficient to alter the flow of business between
the two nations, affect prices in the U.S., or impact business
conditions in either country.
Do not be led astray from recognizing the true implications
and importance of this monumental announcement! I am confident
that this will be the first in a series of sporadic incremental
increases in the yuan’s value. They will be against
the U.S. dollar and likely to a lesser extent the currencies
of their other major trading partners. This will allow China
to gradually gain a stronger foothold in the world economic
arena, which in the not too distant future they may greatly
influence, and even dominate.
Throughout history nations with strong currencies have typically
not only been highly influential in the world’s marketplace,
but have often taken leadership roles in both politics and
the military. When one country’s monetary unit was greatly
desired by those living in other domiciles, it meant that
they offered goods and services that were either highly desirable
or were more reasonably priced than those of their global
competitors. Further, under the gold and gold-exchange standards
it indicated that the country was also fiscally responsible.
The stability and strength of their monetary units attracted
large capital inflows due to the perceived safety that their
countries and currencies afforded. I believe that the recently
announced revaluation of the yuan is China’s first step
toward achieving these goals.
If the yuan is allowed to continue to appreciate, it will
benefit a number of conditions within China. It will lessen
their cost of imported commodities such as oil, iron ore,
cotton and copper. These are priced in dollars and are greatly
consumed by their industrial and manufacturing bases. This
can act to maintain or even reduce their general price levels.
Further, they will be capable of purchasing American-made
products at a discount due to their stronger currency.
China’s benefits may be huge. Over time, as their medium
of exchange further appreciates, it will act to stem the influx
of dollar credits entering China. This will result because
the cost of their exports will become more prohibitive to
Americans and fewer purchases will be made. This will limit
the increase in their money supply thereby reducing their
inflation rate. Further, it will simultaneously help to shore
up their banking system and tend to moderate their overheated
economy. Additionally, the average Chinese citizen will experience
an enhanced standard of living. This will result from the
lowered local prices of both U.S. imports as well as their
commodity laden domestic goods.
The major negative effects of China’s announcement will
be upon the United States and our dollar. First, by severing
its tie to the dollar, it somewhat distances itself from its
dependency upon our currency and will simultaneously increase
the yuan’s reliance on the currencies of the “basket”
countries. Thus, the dollar’s status and desirability
as the premiere global monetary unit will suffer. Next, as
the yuan rises against the dollar it will act to export inflation
to our nation.
One of the prime reasons that prices have been subdued in
the U.S. was due to not only the cheap Chinese import prices,
but to the affect that it has had upon our local manufacturers.
They have been forced to absorb much of their cost increases
in order to remain competitive with Chinese imports. Now,
they will be able to raise their prices in sync with the yuan’s
upward adjustments. Also, American bond prices will likely
weaken. This will result from the reduction of Chinese purchases
of our Treasuries as their dollar inflow subsides.
Our nation has been hemorrhaging dollars through our ongoing
current account and trade deficits. During the past few years
the Chinese have been the second largest dollar acquirer.
They used many of these to purchase U.S. Treasuries and presently
hold about one quarter of a trillion dollars of our debt.
If the Chinese move away from the dollar in favor of other
currencies, the support that they have given our bond market
will dwindle. And, with it, U.S. bond prices can plummet causing
our interest rates to soar.
The U.S. housing market and economy rest on fragile ground.
Any rise in our interest rates has the potential to knock
the legs out from under them. This can cause home prices to
fall precipitously which in turn can shock consumers into
withdrawal, and damage our business sector.
On a positive note, if the yuan significantly appreciates
against the dollar, it will positively impact our manufacturing
base. This may act to reverse its decade long decline, and
may even stimulate it to expand, thereby increasing our employment
Finally, gold has the potential to be a major beneficiary
of a sustained rise in the yuan. Given the fact that the dollar
has heretofore been seen as the world’s primary monetary
safe haven, it has attracted great demand. If the dollar loses
its prominence in the world’s eyes, gold will be the
likely entity that will fill that void and most benefit.
All of the major economies have been aggressively inflating
their money supplies. This has sent tens of billions of dollars
of the primary currencies searching for safety. A floundering
dollar is surely destined to cause a redirection of much of
this money to gold. Given the fact that the yellow metal recently
broke through major overhead resistance in the euro, yen and
Swiss franc, further strength in these currencies should attract
substantial gold buying from these nations.
A negative consequence that a rising yuan may have in China
is damage generated by a potential influx of speculative money.
Given the yuan vs. dollar revaluation, hedge funds and other
speculators are carefully assessing their future exchange
rate potential. It is likely that when the composition and
weightings of the soon to be announced “basket of currencies”
becomes public, the currency pirates may shortly act. They
will be better able to evaluate the accuracy of the parities
between the yuan and the currencies of its trading partners
in the basket.
More importantly, this group will recognize that we have not
yet seen the last increase in the yuan vs. dollar parity.
If a substantial amount of these hedge funds and traders arrive
at the same conclusion their buying of renminbi in anticipation
of this event, can force a sharp upward revision in its value.
They may act, as George Soros did over a decade ago against
the British pound. They will not drive it far lower as they
did with the pound, but may instead carry it decidedly higher.
When dollars enter China most are exchanged by their central
bank for newly created yuan, thereby increasing their money
supply. This is the prime reason for their present level of
inflation. The received dollars are then used to purchase
U.S. Treasuries. If speculators and hedge funds feel confident
that the yuan’s rise over time will produce important
profits, a substantial inflow of dollar credits may enter
their country. They will buy yuan with the expectation of
selling them later when they are worth more for a profit.
In this event, the Chinese government may be forced to capitulate
and quickly revalue the yuan in order to prevent further internal
damage. While this occurrence is far from assured, Chinese
officials must be vigilant.
No one knows how the yuan’s subsequent rise against
the dollar will unfold. Further, we do not yet know the composition
of the Chinese basket of currencies against which its currency
will float. As Richard Russell (dowtheoryletters.com) opined
after the announcement, it might even include gold! If this
is destined, gold will quickly be thrust back into the limelight
of the world’s monetary system. But, what we do know
is that the dollar’s hold on the throne of global currency
domination has been deeply shaken, and is now in jeopardy.
The above was excerpted from the July 24, issue
of Financial Insights, and was completed last weekend. Yesterday,
Tuesday, the Chinese People’s Bank released a statement
denying that they had plans to further revalue the yuan against
the dollar. This brought to mind a situation of which I learned
during the 1960's, and that was not an uncommon occurrence.
Governments have forever done their best to defend their currencies.
“Jawboning” was a commonplace term used during
the 1970's and earlier. It referred to a government’s
attempt to apply pressure and frighten market participants
who were trying to drive lower their currencies. One method
that was often utilized, and frequently occurred just prior
to a devaluation, was an official statement that they would
I cannot say with certainty that the recent revaluation of
the renminbi will be followed by another as I would have expected
during the earlier era. However, the immediate Chinese response
to the numerous statements that the yuan will decline over
time, gave me pause. I now must wonder if the currency pirates
have already begun an attack. In any event, I believe that
China’s Central Bank is quite concerned, and may act
in this regard far faster than many onlookers believe.
The above was excerpted from the August 2005
issue of Financial Insights © July 24, 2005.
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