The dollar peg is crucifying China. It needs to break it

China’s economy is hitting the skids. Boiled down to its simplest terms, the problem is that China’s money supply is too small and that’s serious.

Spotted in China recently:

– a stock market crash
– a bailout of a giant state owned steel company
– money flowing out of the country
– emergency interventions by the central bank in the financial markets
– $400bn spent on propping up the currency and stock markets

Obviously, the economy is hitting the skids. Some new data released earlier this week hints at what’s going on over there.

Boiled down to its simplest terms, the problem is that China’s money supply is too small. That’s serious! When a country’s money supply is too small, you end up with deflation, stock market crashes, recessions, unemployment and financial crises. Bad bad stuff. The kind of stuff we’re already starting to see in China.

I’ll explain what’s so scary about the latest data in just a minute. But first, I want to quickly talk about how we got to here.

Here’s what the guardian of China’s money supply, the PBOC, has been up to for the last few years.

China’s big plan: the peg

For a long time, the PBOC has had a simple plan: juice China’s economy by printing money. The way it did this was to print renminbi (which is China’s currency) and use the newly printed renminbi to buy dollars.

This is what’s called a currency “peg”. It means that China’s currency was “pegged” at a level cheaper than it otherwise would have been. That made it easier for Chinese companies to sell their stuff in foreign markets.

And the peg worked very well for a long time. The dollar peg has been the backbone of China’s economic policy. It’s helped China to grow like crazy, led by its huge new export industry.

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The problem with pegs

But there’s a problem with currency pegs: the “other” currency, to which your currency is pegged, isn’t fixed in value. It moves around. So in order to maintain the peg, you have to loosen or tighten the money supply in your own country accordingly.

Something like that is happening right now in China.

The renminbi is pegged to the dollar, and the dollar has suddenly gotten way stronger over the past year or so. It’s now at a 12 year high, relative to its trading partners. This chart of the US dollar index, which shows the strength of the dollar relative to other important currencies, shows how much the dollar has risen:

US dollar index

Source: Federal Reserve Bank of St Louis

And as the dollar has risen, the PBOC has been forced to tighten China’s money supply to maintain the peg at the same level.

That’s a dicey move! Like I said before, tightening the money supply can have very bad consequences.

Which brings me back to the data which was released earlier this week.

The new data says China is screwed

The new data shows China has started to tighten its money supply in a big way. Nominal GDP is the key variable to watch out for here.

Nominal GDP shows the sum total of all spending in the economy at market prices, unadjusted for inflation. It’s worth watching because it shows whether the money supply is too small or too big for the economy.

If the money supply is too big, you’ll see nominal GDP rising too fast (inflation, in other words). If the money supply is too small, you’ll see nominal GDP rise too slowly (deflation, recession, financial crises, unemployment, stock market crash).

As the pink line shows in the chart below, China’s nominal GDP is falling fast.

nominal GDP growth

Source: Atlas

See the way it’s just recently crossed over the grey line? That means that as of this quarter, there is deflation in China.

Deflation is a classic symptom of a too-small money supply. Now, deflation is not always a disaster. But it’s a disaster when the rate of inflation/deflation changes quickly. If deflation arrives out of the blue, companies start to default on their loans and the other bad consequences show up.

In the latest data, China’s real GDP figures came in better than expected. But history says that it’ll be very hard to keep that up if nominal GDP keeps falling – ie, if the PBOC keeps the money supply tight.

The solution

The dollar peg is crucifying China. It’s going to have to abandon it and allow the renminbi to float freely, like a normal country.

Until China breaks the peg it won’t be able to adjust its money supply. And until it adjusts its money supply, tight money will play havoc with China’s economy.

It’s as simple as that.

Best wishes,

Sean Keyes
For The Daily Reckoning

p.s. I’ve cut out a lot of detail to boil this story down to its essentials: China’s mini devaluation back in August, the way the money supply gets transmitted into nominal GDP, the reasons why the dollar peg is unsuitable now when it was suitable 10 years ago.

I’ve kept the important bits. But if you think I’ve missed something important let me know at [email protected], or in the comments section.

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