Want to Protect the Dollar? Move to China

The currency exchange rates of every country in the world are based on a concept called the Purchasing Power Parity (PPP). This concept says that a currency’s value is based upon the total number of products that can be bought with a single unit of that currency. So if USD$1 buys two McDonald’s apple pies in the US, while RMB1 (Chinese Renminbi) buys only one McDonald’s apple pie in China, then the exchange rate between the US and China would be RMB 2 = USD$1, since an American would then be able to exchange his US dollars for Chinese RMB in China and be able to buy the same number of pies there as he would have in the US.

In the modern world, exchange rates do not always adhere to the PPP. The exchange rates are decided by supply and demand, so if the demand for a currency rises while its supply stays constant, its price or exchange rate rises against all other currencies. The exchange rate decided by supply and demand is the nominal exchange rate, while the rate prescribed by PPP is the real exchange rate. In foreign exchange transactions, the nominal exchange rate is honored, while the real rate is simply used by economists to study a country’s real prosperity.

Many developing countries influence the nominal exchange rates of developed countries so they can export their produce to them. As the developed country’s currency rises against the developing country’s, it becomes more profitable for the developed country to import products from the poorer country.

However, if real exchange rates were to be used in daily transactions instead of nominal exchange rates, there would be no opportunities for the developing countries to export to the developed countries, since PPP would ensure that the same dollar buys the same two apple pies in both the US and China.

Subsequent to this, the developing country, say China, would export huge quantities to the richer country, say US. This would make an average American richer and an average Chinese poorer. However, despite the inflow of goods from China and the increased PPP for the US, the US`s real exchange rate is still worse off than its nominal exchange rate, which has been artificially propped up by China.

A prudent American would use the opportunity to take his/her dollars and change them for Chinese RMB and move to China. Since the nominal exchange rate between the US and China is in the favor of the US, it would be wise to convert all available dollars before China changes its mind and stop inflating the US dollar by depegging its RMB from the US dollar. This would lower the demand for the US dollar and bring the ollar to its true value, which should be close to its real value as decided by PPP.

As things stand, both the US and China are set to suffer severe recessions. China is unlikely to depeg the RMB until the inflationary pressures in the US rise and China is required to buy more and more US dollars to keep the dollar high in value. For at least the next few quarters, the US would see deflation, and that gives a suitable opportunity to Americans to exchange their dollars since the US dolllar should become stronger in the near future.

Comments

[y1531y:]

America - prints and destroy the dollar.
China - collects and protect the dollar.

Jun 24 08:41 AM

[Ferdinand E...:]

So China is set to suffer a severe recession, is it? You mean that its growth rate will fall 5 or 6 percent? I don't call that a recession - I call it a breathing spell.

Jun 24 09:04 AM

[coreopsis:]

A seriously uninformed article which is in complete disagreement with the World Bank, OECD, IMF, Goldman Sachs, take your pick. 'A little knowledge is a dangerous thing."

Jun 24 09:08 AM

[D7:]

I see you are proactive and using symbol to illuminate your thesis. I agree wholeheartedly that the "ollar" will fall in the coming decade. I think I would have taken a bit more off, perhaps calling it the "llar."

Jun 24 11:28 AM

[HaavBline:]

The concept of PPP is useful in economic analysis, but dangerous if applying incorrectly to investment strategy.

The is not much PPP in goods, especially low-value-added commodities. The PPP lies in services. One gallon of gasoline cost as much in India as it does in the US at wholesale. But $20 buys you a basic haircut in the US might buy you 15 basic haircuts in China and 50 basic haircuts in India (just guessing).

But equalization of PPP in service happens in a very slow pace, may 50 to 100 years, if ever. The most important factor being the population density and the ACCUMULATED wealth of that whole country through history. A few years even decades of high growth will not change that.

Jun 24 11:41 AM

[user396040:]

Very helpful analysis. I think a recent development of interest is Chinese export restrictions - China restricts the exports of various minerals because, due to the currency distortion, they are very cheap in dollar terms and would be snapped up by US buyers in the absence of export restrictions. When I traveled in central China recently, it was my experience that prices were absurdly cheap in dollar terms.

Jun 24 12:11 PM

[Albrtertt:]

with risk returning to the markets the dollar still has much further to fall

hat tip to investmintideas.blogsp.../ for the good articles

Jun 24 07:46 PM