Yuan:dollar peg allowed to "move"

For years governments around the world, especially Europe and the United States, have been trying to convince China to relax its pegging of its yuan currency to the U.S. dollar.  Normally currencies are allowed to fluctuate in value relative to one another.  In theory changes in the exchange rate between two currencies should reflect changes in the economies of the two countries in question.  For example, if China’s economy is growing faster than the U.S. economy then investors will want to invest in China to experience its higher rates of return.  This demand for Chinese financial assets increases the demand for Chinese yuan.  That’s because to invest in China you have to have Chinese currency.

Well China’s economy has grown much, much faster than the economies of Europe and the United States for almost 20 years, but the Chinese currency has not been allowed to appreciate.  This is because of the artificial peg held in place by the Chinese government.  The effect of this is that Chinese goods remain artificially cheap relative to goods sold in other nations.  China, in case you have been in a cave for a decade, manufactures most of the world’s low-technology stuff.  So China has continued to grow rapidly and its central bank has accumulated massive amounts of U.S. dollars.

Understandably, the rest of the world is coming to view this arrangement as being patently unfair.  To mitigate against the potential for political fallout China has long bought the governmental debt of its trading partners.  That means they lend us money so that we can buy their stuff.  A neat little arrangement…if you are China.

Along came news this weekend that China was finally going to relax the fixed currency peg and allow the yuan to rise in value.  Financial markets welcomed this news as investors felt this would help strengthen the global economy sans China.  But what is China really agreeing to do?

The yuan appreciated in value in trading yesterday by about 0.4% –  meaning that the Chinese did not act aggressively in currency markets to hold the fixed rate of exchange.  However, this 0.4% appreciation is well within the Chinese government’s “peg range” of appreciation of up to 0.5%.  And trust me, currency traders were more than willing to bid up the yuan had it been allowed to be bid up.  What this means is that China is trying to defray criticism of its economic policies by making the big public gesture, but without actually doing anything.

In fact, Chinese businesses are not run for profitability.  Instead they are run for full employment.  The social contract between the Chinese single-party communist government and its people is: we will oppress you and give you no political options in exchange for you being able to be employed.  What this means is that many millions of businesses in China are not making money but are allowed to continue to exist because they employ folks.  If China allowed its currency to appreciate then the minimal amount of profitability in the Chinese economy would erode.

At some point China will need to restructure its economy to increase profitability and sustainability.  But guess what?  That day is being pushed into the future.  If China were really interested in allowing the yuan to float upward relative to other currencies it would first have implemented new economic measures to increase profitability.  It didn’t do this as it would lead to anarchy throughout China.  In other words, we are highly unlikely to see meaningful yuan appreciation anytime soon.

As investors it behooves us to ignore Chinese currency rumblings unless they are also accompanied by economic structural changes.

Jason