By the time you read this blog, it is most likely that the US Federal Reserve will have announced its increase on excess reserves. This policy will charge banks to keep more money than they need with the Federal Reserve. Banks are supposed to react to this by raising interest rates in order to cover the cost through arbitrage. Its a bit more complex than just increasing the bank base rates – but this is the result of the Federal Reserve having a balance sheet the size it has.
With the expected raise in place, several things are expected to follow. One is that more money will flow from emerging markets toward the US, in anticipation of the higher returns. As part of this expected flow, funds will flow from China toward the US. This will drive the value of the Chinese currency down. At this time, China is doing its very best to hold the renminbi to the dollar to help control inflation and to stabilize exchange rates in order to support exports. Any change in the dollar/renminbi exchange rate will impact Chinese exports will hit and its struggling economic growth will be further challenged.
In the last week the Chinese central bank (PBOC), anticipating the US Fed rate change, has announced that it will no longer peg its currency to the dollar but to a basket of currencies including the euro, yen and sterling. This is a clever move as it will slow the translation of a change in the value of the dollar and the Chinese currency. It takes weeks for changes between the dollar value to ripple through all the currencies in the basket used to value the renminbi. And between all the currencies are a number of central banks, each one managing its own relationship to the dollar.
The PBOC’s tools to defend its currency include spending its vast exchange reserves. And it has been actively doing this very recently. The PBOC has vast reserves but any signnificant change will be noted by the market and impact the confidence in the PBOC’s ability to cope with external forces. No one can afford that loss of confidence. With a basket of currencies between the dollar and the renminbi will slow the transmition of changes in the dollar to the renminibi, and so mute the need of the PBOC to sell its reserves to defend changes due from rises in the value of dollar that is likely to start tomorrow.
The issue is this: the US economy, the global economy, relies on Chinese growth (and increasingly India’s growth), to keep the rest of the place moving forward. The global economy cannot expect a change in fortunes from US, euro, or Japense growth. If China were to slow down any more, and significnatly, we will all be in trouble. So an appreciating dollar will slow the Chinese economy, if not the global economy. So if you keep your eyes on the Fed’s actions and not focus on the PBOC’s actions, you might miss the more important action. The Fed’s behavior is predictable; the PBOC is not so clear, and its actions may have more profound impact on our futures.