The dollar is still going to be a big piece of the reserve pie in China. First, we don’t assume the Chinese would have left reserve diversification until after the revaluation. But even if they did, the undisclosed basket of currencies that will be the basis of the new floating renminbi must consist largely (probably about 50 percent) of dollars or dollar pegged currencies such as the Hong Kong dollar. The need for serious diversification on a transaction basis is low. The only reason to diversify much or to talk about diversification would be political — to “punish” the U.S. for some other action in the military or diplomatic sphere.
It took a lot of wind out of speculative sails to acknowledge these points. Not much has changed. The U.S. will still be running massive trade deficits with China, and China will still be holding massive amounts of U.S. paper.
One other thing is becoming clear: By depriving speculators of a fat, one-time gain, China is only inspiring them — and probably a new group of speculators, to boot. Hot money capital inflows can only rise. Because the Chinese are very smart about how markets work, you have to wonder if this is not their intention. They complain about the inflationary effect of inflows, but for some interim period, inflows must be what they want. Developing economies always want capital inflow, and China has had it in spades over the past three years. This is not really different from the powerhouse U.S. economy funded by European capital inflows in the 1800s.
If hot-money inflows into China grow bigger as the rate is seen to be managed at too tame a level, the Chinese can continue to sterilize them by buying up the dollars and then investing them in Treasuries, as before; the yield on the 10- year bond can remain constrained. The current thinking is that rates would be about 1 percent higher were it not for foreign (including Chinese) demand for U.S. paper. The housing market is safe from precipitous rate increases.
But hot capital flowing into China can spill over to Taiwan, S. Korea, and elsewhere, in a speculative effort to get them to UN peg, too. This means outright dollar sales, so the net effect is dollar-negative. In fact, according to this view, the dollar must fall because the 2.1-percent revaluation is too skimpy. It needs to be more like 30 to 40 percent to stop the interest-rate/dollar game and establish stable relationships.
Therefore, the Chinese choice of a token 2.1 percent revaluation is not a stabilizing influence on the global imbalance, but potentially a destabilizing one — and discord within the Chinese government about the extent and timing of additional moves is a frightening prospect.
Do the Chinese really have a plan, and what is it? The Chinese announcement contained magnificent statements to the effect that China seeks “to enable the market to fully play its role in resource allocation,” but China’s goal is not to revalue, it’s to build a sustainable forex regime. It is in this sense that what’s in China’s best interest is not necessarily what’s in the interests of the rest of the world.
Because the Chinese central bank reserves to itself the right to adjust the renminbi band whenever and however it chooses, we now have the tiresome task of following the pace and extent of upcoming renminbi price changes and how they affect trade and capital flows, if any.
Clearly the benchmark Euro/dollar exchange rate can’t stay stuck forever in the range, but until we have a better view of the Chinese thinking on the subject — and actions speak louder than words — the main currencies are hostage to indecisiveness and range-trading.
Keep your eyes peeled for the breakout of either the support or resistance line.
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