China Severs Peg To Dollar

To better understand the implications of this announcement today, one should consider the financial mechanics of the relationship between the US Dollar and the Chinese Yuan for the last decade.

China had pegged its currency, the Yuan, or RMB, or Renminbi (i.e. Peoples Currency), to the US Dollar at a rate of 8.2 yuan to 1 dollar so as the dollar strengthened, the yuan strengthened. When the dollar weakened the yuan weekend. This meant that the US could never gain a trade advantage over China because the two currencies were linked. But this linkage didn't happen simply by Chinese decree, there was a mechanism that made it so.

That mechanism was basically a manipulation of the two currencies so that if the dollar started to weaken against the yuan, China would purchase dollars with yuan. This would take dollars out of the market creating a demand for dollars and consequently increasing their value. At the same time, the yuan would experience the opposite affect and since more yuan were coming into the market, their value would decrease.

The other scenario is that if the dollar would increase in value against the yuan that was declining in value, China would sell dollars and buy up the yuan.

The net result in either case was that the "peg" would be maintained.

Today, China announced that they have discontinued this policy and, instead, have pegged the yuan to a "basket" of currencies. They haven't announced which currencies are in the basket but they certainly would include the dollar and the euro, and the yen.

There are three observations of particular importance about this development. First, if China has decided to make a change in policy, it is reasonable to assume that the previous arrangement no longer serves their purpose but one can only speculate as to what their ultimate objective is. Two, since the Yuan is now pegged to multiple currencies, the need for China to buy dollars to maintain the peg is diminished proportionally to the mix of the basket of currencies. And three, and most significantly, the need for China to be a buyer of US dollars could be practically eliminated all together.

Consider this:

However, the pressure on China to prop up the dollar will be greatly diminished. To maintain the peg against its new basket, Chinese monetary authorities will most likely now be buyers of those other currencies likely to be included in its basket, such as the Euro or Yen. Since its reserves are already disproportionately held in dollars, it will likely rebalance those reserves to more accurately mirror the basket to which the yuan will be pegged. Such a rebalancing will only exacerbate the dollar's decline. However, a declining dollar will not automatically require offsetting dollar buying by the Chinese as it has during the period of the yuan-dollar peg. As long as dollar weakness is offset by strength in others currencies in its basket, the peg can be maintained.

There's much more important information regarding the consequences of today's action at the link such as:

1. Higher consumer prices.

2. Higher interest rates.

3. Reduced profits for American companies, particularly those dependent on domestic consumption and consumer debt.

4. Lower stock prices, as earnings decline and multiples contract.

5. The busting of the housing bubble, as tighter credit standards and higher interest rates squeeze current home prices.

6. Rising unemployment, as higher interest rates and vanishing home equity slow consumer spending and reduce jobs dependant on that spending.

7. A severe recession as a result of all of the above.

8. Rising federal budget deficits, as recession reduces tax revenue, while higher interest rates and escalating outlays increase expenditures.

One can only wonder what congress was thinking as they threatened China to break the peg to the dollar or we would slap a 27% tariff on the goods we import from them. D'oh!