The $3.6trn showdown in the currency markets

There’s a simple explanation for what’s been going on with the Chinese economy lately. China is suffering the effects of tighter monetary policy.

I wrote a guest essay for the Daily Reckoning back in October, about the chaos in Chinese markets. It was called ‘The Dollar Peg Is Crucifying China. It Needs To Break It’.

In the piece I said there’s a simple explanation for what’s been going on with the Chinese economy lately.

Well, last week there was some more news on that front: the stock market was shut down by the authorities, after it crashed more than 7.5% in less than half an hour. And the Chinese currency, the yuan, came under attack.

It’s all coming to a head.

Here’s what’s happening…

Less money, mo’ problems

In a nutshell, my article in October made the case that China is suffering the effects of tighter monetary policy.

Monetary policy is the system a country uses to control its money supply. Here in the UK it’s the Bank of England’s (BoE’s) job, and it controls the money supply by targeting interest rates.

The BoE uses interest rates to keep the economy at ‘the Goldilocks level’ – not so much spending that there’s inflation, not so little that there’s recession.

For example – when the BoE wants to cool the economy down, because it’s worried about inflation, it raises the target interest rate. This causes the money supply to shrink, which causes the economy to cool down. This is an example of tight monetary policy.

In China, the People’s Bank of China (PBOC) controls the money supply…

It’s trying to do the same thing as the Bank of England – to keep the money supply at the right level for China, so that there’s not a lot of inflation or a recession. At that level the PBOC and BoE are doing the same thing.

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The big difference is that China’s a developing economy, which is growing very quickly. The BoE would be happy if the UK economy grew by 2%, but the PBOC needs to keep China growing at around 7%.

And there’s another very important difference between how the PBOC runs China’s money supply and how the BoE runs Britain’s. Like I said, the BoE targets interest rates. But the PBOC targets the exchange rate instead.

What this means is that China’s money supply is used as a tool to keep the exchange rate at a specific level relative to the US dollar. China wants the yuan to be cheap relative to the dollar, so it prints yuan and buys dollars. It’s what’s known as a currency “peg”.

The currency peg has been a big success for China. It’s part of the reason why China’s export industry is so successful.

But there’s a problem with currency pegs. A peg means you hand over control of your own monetary policy. Instead of choosing the money supply, which keeps your economy running smoothly, you choose the money supply which keeps your currency at its pegged rate.

So whenever the dollar gets weaker, China prints more yuan to keep the two currencies “pegged” at the same level. And whenever the dollar gets stronger, China tightens the supply of yuan.

In the last few years the dollar has risen in value. So to keep their peg going, China has had to cut its money supply.

In other words, Chinese monetary policy – and therefore the Chinese economy – is at the mercy of America. The stronger the American economy gets, the stronger the dollar gets, the more the PBOC is forced to tighten the money supply.

Cutting your money supply is usually a bad idea – especially in a fast-growing economy like China. The monetarist textbook says that this should lead to deflation and unemployment.

What’s happening on the ground? Well, the most recent figures show that China experienced deflation in the first quarter of this year – which is pretty much unprecedented for a fast growing country like China. Unemployment is up.

The $3.6trn showdown

All of this means that the peg, which has been the cornerstone of China’s economic policy for a long time, is coming under pressure.

People are asking whether it’s really such a good idea for China to tighten its money supply right now.

Currency market traders are betting that the answer to that question is “no”. They’re speculating that China’s going to have to abandon the peg, because China is clearly in need of a bigger money supply right now.

And while it’s part of the peg, the PBOC can’t freely print more money.

The PBOC is trying to defend the peg by selling dollars and buying yuan. It had $3.6trn in foreign reserves last July, but it’s burning through that at an alarming rate.

It spent $120bn in December alone, twice the previous record. At that rate, even $3.6trn won’t last forever.

A couple of hundred billion here, a couple of hundred billion there, and pretty soon you’re talking real money…

All the while, China’s real economy is in pain. The Shanghai exchange was shut down by the authorities last week after the Shanghai composite index crashed by 7.3% in less than half an hour. Growth has stalled and deflation is a real worry.

China needs more money printing. But China’s currency peg won’t allow it.

Something’s got to give.

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