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China in a Bubble?

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By rclosch
December 2, 2009

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The premise of "The Lords of Finance" is that exchange rate imbalances distorted the economies of the countries involved causing the eventual build up of pressures that led to a financial eruption that broke the world's economy.

It is possible to find in these details some fascinating parallels to present problems in world trade. Today most of the world operates on a system floating exchange rates that were set up after WWII specifically to prevent a repeat of the problems that Mr. Ahamed describes in his book. There are exceptions to the floating rate system the most notable of which is that China and certain other Asian countries have chosen to peg their currency to the dollar. So the question for today's reader is what are the chances the Renminbi's link to the dollar will eventually lead to the kind of disaster we saw in the thirties?

The Chinese Renminbi has been undervalued relative to the Dollar for quite a while, as to the extent of that under valuation no one knows for sure, but I have read estimates the run as high as 30% to 50%. One thing we know for sure is that it was over 20% higher three years ago. From 2006 to 2008 the Chinese government allowed the Renminbi to appreciate by 20% against the dollar. Despite this adjustment we are still running a trade deficit with China today. This imbalance is the result of intentional and continuous intervention by Chinese monetary officials in the currency market to keep the Chinese currency undervalued. They do this because it benefits their economy by giving Chinese goods a competitive advantage in the American and world market place. This is great for the Chinese companies that produce these goods and for the American Consumer. Unfortunately, this imbalance also steals jobs from the American Economy and lowers wages for American workers.

There is an interesting parallel with of our situation today and to what was happening in the thirties, only this time, for America, the shoe is on the other foot with China the country that is experiencing trade surpluses and huge currency inflows. Which if the parallel holds could mean China as the country that is steaming toward the iceberg.
Now, we find that United States is in a position similar to Britain in the 1930's where an overvalued currency was destroying the counties competitive position in world trade. Actually we hear the same arguments today from Washington as British politicians used in 1925 justify a $4.84 Pound. It was based false pride in their currency that ignored economic reality and the countries best interest.

Currently we also hear grumbling by Chinese government officials about acts of American protectionism such as the tariffs that are imposed on steel imports. They conveniently ignore the fact that these tariffs are small compared to the price advantage that they gain by refusing to let Renminbi appreciate. The currency problem is compounded by the fact that the Hong Kong Dollar and the Singapore Dollar are also pegged to our Dollar. This means that as the U.S. Dollar depreciates goods from these countries get cheaper compared to goods produced by the rest of the world. This again is great for China and Hong Kong, but not so great for the rest of the world. The pain is being felt particularly in Europe where the already overvalued Euro is appreciating against the dollar and because of the peg against the Renminbi. This is a ludicrous result that gives Chinese products a competitive advantage over products from the developed world.

The financial press and American politicians are currently in a state of panic about the fate of the US Dollar. What they should be concerned about is the under valuation of the Renminbi. Since the Dollar is now undervalued against most of the currencies of the developed world one should wonder whether this is really a dollar problem, and it is not really a Renminbi problem.

US trade deficit has been cut in half in the last year and half, how much of this is a result of our recession, and how much is the result the Renminbi appreciation while it was unpeged is an open question, but what is to say that the remainder of our trade deficit would not disappear if Renminbi were allowed to appreciate to a real parity with the Dollar?

One story that is a long way from finished is the one about the Chinese currency. China has benefited mightily in the last ten to fifteen years from their governments currency policy. But few benefits go for long without becoming mixed. Whether this kind of stimulation will lead China to the same destination that American reached in 1929 is an interesting question. Jim Grant says China is a Bubble, and that the end is a question of when not if. The country has been working industriously for years to create the psychological basis necessary for bubble formation. So stay tuned.