QE2 worsens China’s currency dilemma

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Whatever the effects of QE2 on the US, its impact on China will be major. Because China has attached its renminbi to the dollar, the ‘dollar economy’ consists of the US and China - the so-called “Chimerica”, though as an optimal currency area it might better be called Chimera.

In this dollar economy, China is heavily undervalued (though nobody can assess by how much) and the US is overvalued. The Fed’s newly created liquidity could in effect “flow downhill” to the undervalued portion of the dollar economy. Already overheated, inflationary China will get a much larger dose of cost-push inflation in food and energy than the US.

Food is one third of China’s CPI, versus 14 per cent in America. This makes the recent 20 per cent rise in food commodity prices more important. Meanwhile, China’s competitive leg-up vis-à-vis Japan, Korea, Germany and others will be exacerbated by a further 5 per cent trade-weighted devaluation (in line with the dollar) - a currency impact that is likely to take effect much more quickly than any benefit from devaluation to the US. So higher Chinese inflation arising from QE2 is a double-whammy: demand-pull as well as cost-push.

As well as raising export demand in an overheated economy, higher inflation could provoke a greater tendency to invest, which already takes a hugely wasteful 47 per cent of GDP. As the upward response of nominal interest rates is heavily constrained by political decisions, the increasingly negative real rates mean a negative real cost of capital, which is an invitation to waste.

Domestic demand needs to be restrained to eliminate existing overheating, subdue the extra arising from devaluation under QE2, and curb the cost-push inflationary effects. This restraint is liable to fall entirely on consumer spending, arbitrary administrative cuts in investment, and a sharp fallback in real estate (where recent building sales have been down on the year before with starts still up some 75 per cent).

As a result of QE2, the full inflationary cost of maintaining the renminbi-dollar peg has been brought home to Beijing.

The alternative to renminbi appreciation has always been US deflation or Chinese inflation. The latter might have seemed preferable to Beijing, but it would, if accepted, have had damaging consequences for the whole world economy, including export-led China. But QE2 shifts the emphasis heavily toward Chinese inflation, and potentially trashes the nest-eggs of the urban middle classes.

Inflation is more disruptive for the leadership’s political position than slow growth. Moreover, because QE2-driven food and energy prices are actually liable to reduce US domestic demand over the next several months, there will be some malignant effects on China’s export business. And when, next summer say, QE2 is seen not to have rescued the US from slow growth, the dilemma of President Obama, seeking re-election a year later, will be acute. At that stage, if the Republicans deny him the easy option of a general tax cut, the option of surcharging Chinese imports may seem the only action he can take.

“Double-whammy” scarcely does justice to the risks China faces.

http://blogs.ft.com/beyond-brics/2010/11/05/guest-post-qe2-worsens-chinas-currency-dilemma/

[spookyturtle 9,465]

I thought the QE2 was a ship.

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I thought the QE2 was a ship.

there have already been threads on it!

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Here is a pretty good comment from a reader on this page.

QE2 seem to do three things:

devalue the dollar – increase competitiveness of the our imports

decrease the real wage – inflation in commodities/products, higher profits, while wages remain the same, the labor market clears – competitiveness of our imports goes up

flush “money bags” out of the treasuries and into productive investments – “money bags” are forced to put it into the stock market, “emigrate” and hope for better abroad in the face of increasing capital flow restrictions or watch it erode through inflation. QE2 is not a friend of the wealthy. Watch the wealthy attempting to forestall QE2 through harassment of the FED by the Republicans and a vilification campaign in the media.

Obama is in Asia right now for the next 9 days to lobby for opening of markets to American companies. If things go well, by the election time he will take credit for engineering an export-driven recovery. People will not be better off than now, but at least they will be employed.

QE2 has been under discussion and in works for many months now. I would guess Geithner got at least a wind of it, why he chose to continue on his path, who knows. Maybe it’s a part of a two-prong good cop-bad cop strategy, with the FED being a bad cop swinging the big keyboard

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Edited November 7, 2010 by \

[Ban Hammer 12,827]

I thought the QE2 was a ship.

ditto. i was like how is the qe2 affecting china? or did they buy that too?

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The Fed's magic money machine annoys the world

... the global outrage can be seen as proof that the Fed's action might actually have some salutary effects for the U.S. economy. If the Fed's stimulus results in a lower value for the dollar, U.S. exports will get a boost. Sound familiar? How ironic, then, is China Central Bank president Zhou Xiaochuan's observation?

"If the domestic policy is optimal policy for the United States alone, but at the same time it is not an optimal policy for the world, it may bring a lot of negative impact to the world."

(Actually, Zhou is a pretty smart guy, and I'm sure he realized that the words "United States" could easily be replaced by the word "China" in that sentence. So what he's really saying to the U.S. is You are now doing precisely what you are so mad about us doing. Does that make sense?)

But Brazil et al. aren't just worried about their export competitiveness. As the Wall Street Journal reported, "they fear that even-lower U.S. interest rates and a weaker U.S. dollar will send capital surging into their own economies, adding to the risk of inflation and asset bubbles."

"The US policy undermines the spirit of multilateral cooperation that G20 leaders have fought so hard to maintain during the current crisis," said South Africa's Gordhan.

Such cries are going to fall on deaf ears in the United States -- neither the Tea Party on the right or organized labor on the left cares much about foreign complaints or multilateral cooperation. And the U.S. obviously has the right -- and responsibility -- to look after its own interests.

But in a world where the balance of economic power is becoming more evenly distributed, going your own way comes with costs as well as benefits. Americans may not want to care about multilateral cooperation, but the world is going to become more multilateral regardless, with or without us. The U.S. was originally hoping to use the G-20 forum to put pressure on China on such issues as yuan valuation and rare earth trade policy. That won't be quite so easy if the rest of the G-20 decides that the U.S. is the real rogue nation.

[mawilson 2,133]

What a fantastic way to screw China.

[luckytxn 2,263]

Poor China.

[godspeed 41]

don't worry about China they are buying gold reserves and make all our products, they only way to really keep from becoming a third world country in comparison to China would be massive tariffs against Chinese imports

they've already dumped alot of their US dollar reserves

The US is in big time trouble with impending inflation, a huge trade deficit, and a debt that is mathematically impossible to pay off.

[spookyturtle 9,465]

don't worry about China they are buying gold reserves and make all our products, they only way to really keep from becoming a third world country in comparison to China would be massive tariffs against Chinese imports

they've already dumped alot of their US dollar reserves

The US is in big time trouble with impending inflation, a huge trade deficit, and a debt that is mathematically impossible to pay off.

Are you really from Australia?

[mawilson 2,133]

a debt that is mathematically impossible to pay off.

You must be bad at math.