Tuesday, June 22, 2010

The Yuan Trap

Be careful what you wish for. American politicians are complaining that the Chinese government suppression of the Yuan is making Chinese exports more competitive.

When the Chinese government issues a statement that they will allow the Yuan to float, markets around the world rallies in the expectation that the Chinese will buy more due to cheaper imports, therefore, the rest of the world can sell more and save their own economies.

However, something else may happen instead. You see, the Chinese government has been buying the US Treasuries to suppressed the value of the Yuan (i.e. USD that goes in through import is cycled back or exported by buying Treasuries). If the government allows the Yuan to appreciated, that means the Chinese government do not need to buy as many Treasuries as they did last time. This means that the Treasuries may drop (i.e. interest rate goes up). Up to a certain point, higher interest rate will hit the home loans in US. When home buyers defaults, bank losses increases. Less lending will result. Business contracts, more retrencement will occur. No jobs means less consumption. US government will collect less tax. Therefore, more Treasuries will be sold which will suppressed the price (since China is not buying that much). This may be the death spiral that will plunge the whole world into a depression.

So, be careful what you wish for.

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