Sunday, July 24, 2005

Chinese Currency Float: The Good, Bad and Ugly

The Chinese government decided last week to de-link their currency from the dollar and instead couple it to a market basket of world currencies. What will be the impact on the U.S. consumer and investor? The timid decoupling announced by the Chinese will increase the price of Chinese goods in the U.S. and lower the price of U.S. goods in China. Thus, it will tend to reduce the U.S. trade deficit with China. However, it is certainly plausible, and even likely, that U.S. consumers will replace Japanese and South Korean goods for the higher priced Chinese goods. Several other less apparent changes will occur in the months ahead as a result of the Chinese action.

First, by increasing the price of Chinese goods in the U.S., the move will contribute to higher U.S. inflation. This will, of course, force the Federal Reserve to more aggressively raise short-term interest rates. The current funds rate of 3.25 percent is the highest since the summer of 2001 and is still accommodative by historical standards. Last week Greenspan, in his testimony ot Congress, strongly hinted that more rate hikes are very, very likely. Allowing the Chinese currency to semi-float will mean even higher rates in the months ahead. Cheap Chinese goods have been an important factor restraining U.S. inflation.

Second, the trade deficit with China has meant that the Chinese central bank has accumulated a mountain of U.S. dollars over the past decade. They have used these dollars to buy U.S. Treasurys, particularly long term instruments. This action raises the price of U.S. Treasurys and lowers the yield (or effective interest rate) on them. This is an important factor that has produced what Alan Greenspan terms a “conundrum.” (Why are long term interest rates so low?) They are so low because our Asian neighbors, including China, have sent their accumulated dollars to the U.S. Treasury. They have been especially generous lenders to a gluttonous U.S. government and big-spending U.S. consumer. Last week the yield on the 10-year U.S. Treasury rose by 10 basis points as a result of the Chinese actions. Expect even higher rates in the near and long term.

If the Chinese become more aggressive in allowing their currency to float in the months ahead, the Fed will deal with this by raising the funds rate by more than I think is consistent with solid U.S. growth. I currently assess the likelihood of an interest rate hike at the Fed’s August 9th meeting at 100 percent. Due to the Chinese action (and likely future steps), we are very likely to see rate hikes for the remainder of 2005 until the funds rate rises above four percent. This will slow U.S. economic growth.

EPG

1 comment:

Jeff Milewski said...

Near future recession lurking?

If I am not mistaken and correct me if I am, everytime the short term interest rate has gone higher than the 10-year rate, a recession has resulted. Overreaction on China's decision to unpeg the yuan could result in Greenspan raising rates too high, resulting in slower economic growth. Will other economic conditions push the 10-year rate higher at a fast enough pace? I say it will not. My thought is that the trade deficit will not be affected enough to slow China's demand of our treasuries, leaving the rate low. The talk of a real estate bubble bursting and a 2006 change in the fed reserve chief, add to the economic concern. So maybe the reason investors have been cautious about buying stocks at a relatively good price is for these reasons mentioned. Terrorism is also in the back of everybody's mind, adding to more caustious investing decisions. Please feel free to respond to my thoughts.