Ladies and Gentlemen,
The following is an explanation of the underlying issues that contribute to fluctuations in our money markets. It should provide a relatively sufficient means for conceptualizing the import of the following Financial Times (FT) article. Please see link for: FT Article: Fed Rate Cut Adds Pressure On China
Economists have been debating the following issue for some time now: If China stubbornly refuses to stop buying dollar denominated assets at a rate commensurate with new Fed money creation (to ’sterilize’ the Yuan/Dollar exchange rate), a growing resistance between real world (market) interest rates and China’s rates will become a rather combustible mixture. Without proper foresight and measured adaptations, this relationship could result in that spring action I was referring to in the ‘State of the Union’ email (2/31/06), whereby currency values fall [suddenly] and interest rates go way up. That would be bad for global price stability and it would throw a lot of businesses into a tailspin. Accordingly, it would behoove US and Chinese policy makers to work together to assuage the issue. But – and this is a big but – the onus of responsibility lies upon the US consumer, as we wouldn’t be in nearly the financial position we are in today if [the average household] were not profligate.
Not to point fingers, but an informed body-politic makes wise decisions, while an uninformed one just decides to put-off hard questions for later (e.g., Social Security and Medicare entitlements unfunded liabilities crises, but I digress).
Let’s use broad strokes to check out the rationale behind this currency mechanism by which the Chinese have been hoovering cash right out of your wallets and furthermore, investigate the consequences of such policy both at home and abroad. First, we’ll briefly identify the primary forces which cause money values to rise and fall, then we’ll proceed with an illustration of how money is created and how the Fed affects interest rates. Next, this email will attempt to concisely identify the process by which China manipulates its currency vis-a-vis the United States in response to Fed actions and suggest the consequences which this policy has for the Chinese economy. Lastly, this email will suggest two or three possible scenarios regarding the relationship of the Chinese and the American, hence, world economy going forward.
Any attempt to explain value fluctuations in what Benjamin Graham (the dean of Wall Street) famously referred to as the ‘abstruse money market’ must begin with the notion of something called an [uncovered] interest parity condition, which works symbiotically with the so-called Fisher effect, such that [the amount of] money supply creation, hence the concomitant relative value (or price) of a currency and rates of interest on said currency, are inversely proportional. Or simply: As the money supply increases interest rates will fall.
The following is an example of the process by which money is created:
The US Government, via our Treasury, writes an IOU, or a bond, with a specific interest rate; the Fed then buys the bond via the Government from the Treasury with cash delivered on order from the Bureau of Printing and Engraving. The US Government then takes that cash and transfers it to commercial lenders (banks) by hiring so- called employees and buying so-called products, with government checks, which are deposited into these institutions as ‘federal reserves’. In a fractional reserve banking system, commercial banks can lend out a certain percentage of their deposits (usually around 90%), while keeping the balance (usually around 10%) on reserve. Obviously, a Fed’s increasing available reserves for banks frees up said banks’ loanable funds and, via the money multiplier, the overall money supply in the economy increases (like tenfold or something).
The actual interest rate mechanism is set in various ways, but in the main, rates charged between banks for overnight loans form the basis for interest rates charged for loans [to entities other than banks] in the economy. The discount rate also has an effect, albeit somewhat negligible by some accounts, but that is the rate banks can borrow (now a half a percentage point or fifty basis points higher than the fed funds rate) directly from the Fed in the short term. This is a stop-loss measure; it’s good for things like liquidity crises (not that we know anything about that).
What China is doing today is essentially buying up incoming dollars with newly issued stock of Yuan/Renminbi to keep the differential values constant between the currencies (i.e., to prop up the value of the dollar against the Yuan/Renminbi). This has a price – namely, the difference in rates of return on Fed bonds and those of China’s money. One one hand, it only costs 2.07% interest to hold US money (based on the current 1-month Treasury yield rate), but on the other hand, that money is only earning a 2.07% return, while the Chinese money rate is closer to 4%. The difference (about 200 basis points or two percent) is what it costs China to buy US monies and ’sterilize’ the currency (to peg the value at a constant rate).
You might ask, ‘Well, why doesn’t China just lower its cost of money and erase the differential or close the gap?’ The reason being, grasshopper, is that China’s inflation rate has been out of control (OC). There have been pork shortages so people have boiled dogs and cats for dinner (no lie), volatility has been on the rise; therefore, companies have a hard time deciding which investments will be profitable. Consequently, companies (mostly run via government through banks) cut back and people lose jobs, this affects a death spiral on GDP/incomes per capita, hence consumption, investment and round and round.
It is costing China a certain amount to hold our currency at the levels which they now hold (there are currently over $1.5 Trillion worth of reserves being held in China, but the exact proportions of that pie denominated in American dollars is uncertain)* and there is an offset between the export-driven gains of holding the currency at those amounts and the fiscal losses due to the costs of money related to holding those amounts. Accordingly, any major decision China makes regarding these funds will have an impact on the United States – indeed, on the entire global economic system.
Generally, neither America nor any country should feel itself hostage to the political fortunes of sovereign wealth fund manager’s or their bosses’ decisions. However, one might say that it is not unwise to try and manage realistic expectations about those decisions for the good of the nation and for the global economy-at-large. To that end, we have two, perhaps three plausible scenarios for Sino-American economic relations going forward:
b) The scenario plays out as in 2a above, except Chinese technocrats respond to the imminent zero hour by financial brinkmanship and subsequent panic after crossing the point of no return (when all foreseeable returns go negative). As a result, financial markets go into a protracted hysteria, businesses get cold feet regarding new investments and the world sinks into a depression.
c) The scenario plays out as in 2a above, and Chinese technocrats respond with financial brinkmanship as in 2b, except the increasing pressure of decreasing margins turns into a critical mass which explodes, not when returns go invariably negative, but when an exogenous supply shock (e.g., leading to a major energy price swing) causes these countries decide that each other’s currencies just aren’t worth what was previously thought and consequently, there ensues a speculative financial collapse, badly damaging the value of debtor nations’ currencies (e.g., US, Britain and the Eurozone) and, by extension, the value of China’s foreign assets**. Thereupon, business investment halts at each nation’s respective borders and a new era of protectionism ensues; world GDP falls by 75% over the following decade.