I find bond trading and foreign exchange trading to be a maddeningly complex topic which is difficult to understand. So when I see that two writers who I follow regularly (
Billmon and
bonddad) are of the opinion that China's decision to remove the Yuan's peg to the dollar could have extraordinary effects on the US economy, I want to figure out what the hell they're talking about, and see if I kind understand what exactly a "peg" is, and how China's decision to "break the Yuan-Dollar peg" could hurt our ecomony.
So, after some non-expert study, here's what I believe is going on. If anyone out there understands these concepts better than me, I invite you to correct this diary. In fact, I am
begging you to correct this diary, because I want to understand how this stuff works.
What is a "peg" and how does it work?
When a government wants to "peg" its currency to another foreign currency, instead of letting it float free in the forex market, it will "peg" its currency by buying or selling large quantities of the foreign currency in order to make sure independent forex traders continue to value its currency at the preferred level. For instance, let's say, hypothetically, that China wanted to peg its currency at 1 U.S. Dollar equals 8 Yuan. But let's say that international forex traders decide that the Yuan is actually more valuable than 1/8 of a dollar, and they start trading Yuan at a rate of 7 Yuan per dollar. The Chinese Central Bank, to maintain the peg, will then buy dollars by the truckload, in order to increase the demand for the dollar and raise its value against the Yuan back to 8 Yuan per dollar.
Why would China "peg" its currency?
China wants to keep selling cheap imports in the United States and throughout the world. However, if the value of the Yuan rose against the dollar, those Chinese imports would become more expensive in the US market, and sales would drop. Thus, China "pegs" its currency at an artificially weak level in order to keep its import prices down.
What effect did the Chinese peg have on the U.S. Economy?
The fundamental fact of the US-Yuan relationship over the past several years is the strengthing of the Yuan against the dollar. Thus, to maintain the peg, the Chinese have had to purchase enormous amount of dollars -- hundreds of billions, if not more. Since the Chinese have all these dollars sitting around, they need to invest those dollars in dollar based assets (in order to get a good rate of return on their dollars), namely, U.S. treasury notes. By purchasing truckloads of U.S. treasury notes, China allows the U.S. to run up a massive budget deficit without causing interest rates to skyrocket. That is because China's massive purchases keep demand for the notes high -- which keeps the price of the notes high and interest rates for those notes low.
What effect will China's decision to "break the peg" have on the U.S. economy?
Nobody knows. But here's the fear. China will stop buying U.S. treasuries at the same time as other entities stop buying U.S. treasuries because those other entities are concerned that the budget deficit is too big and the US may not be able to repay all its debts. As a result, U.S. treasury prices will drop, and interest rates will go up. As U.S. treasury interest rates go up, so will all other interest rates, which could lead to a credit crunch and an economic contraction. Of even greater concern, mortgage interest rates will increase (perhaps dramatically), which could cause the housing bubble to "pop."
These factors could easily lead to a serious economic recession, which would be directly attributable to Bush's irresponsible fiscal policies with respect to the budget deficit.
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I am not economist, nor am I a bond or forex trader. However, I believe the above analysis explains how China's decision to break the Yuan peg could harm our economy. If there are others out there who wish to correct, critique, or add to this analysis, I welcome all such commentary.