The Relentless Rise of the Dollar and Fall of the Yuan

With sentiment at the Fed shifting toward a rate rise in June, and news today in the Wall Street Journal (see China loses resolve to revamp Yuan) that China is again worried about the pressure on the Yuan, we can all predict what is about to happen. 

The low interest rate the Fed promotes has been described as a response by the Fed to the lack of active policy by the US government to drive economic growth. The market distortion as a result of the low interest rate are frightening. There was a piece, albeit an opinion, in yesterday’s Financial Tines that explained the impact on savings (negative), retirement planning (disastrous), and debt (growing toward all time highs again).   But we will not change the government’s actions overnight, not until November that is, and even that is not guaranteed. So we are stuck between a rock and a hard place. The Fed wants to raise rates but has to avoid chocking off the meager growth that is limping along.

China has its own economic challenges. As it wrestles with the gradual transition from a manufacturing based economy to a consumer and services based economy, it is using the exchange rate to control its export competitiveness. Note that in recent times, in studying the UK’s transition between late 1950’s to the 1990’s, this effort won’t be easy or quick. But China is trying to move quickly, perhaps too quickly.  And despite the IMF signaling it’s faith that China was going to let the market drive the Yuan’s exchange rate, the People’s Bank of China (PBOC) continues to take action to stabilize its currency. 

Assuming the Fed increase interest rates in June, we will all hear that big sucking sound again as capital flies from emerging markets including China back to American shores and the powering dollar. This will trigger a fall in the Yuan and the PBOC will again start to leverage its foreign exchange reserve to stem the losses. That reserve has fallen from an estimated $4th to about $3.2tn in the last year or so. The question is, how far can that reserve go in defending the Yuan?

Sterling was ‘broken’ in the 1970’s and the U.K. Government had to go to the IMF for a loan – check out “Decline to Fall: The Making of British Macro-Economic Policy and the 1976 IMF Crisis, Douglas Wass, 2008”.  That was a low point for the UK. The pound was again ‘broken’, perhaps more famously, by George Soros during ‘black Friday’ when the UK was forced to leave the Exchange Rate Mechanism (ERM), a pegged exchange-rate system that preceded the single currency, the euro. 

Clearly the PBOC won’t use up all its reserves. So the question becomes: what is the level at which the market expects massive red flags? Perhaps a leading indicator to watch are the monthly reported FX outflows from the PBOC. As that ramps up, the red flags will start to fly. And they won’t be the party flags of choice- they will be the economic panic flags that none of us want to see.

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