Chinese Currency's Gradual Appreciation: How the US Economy Benefits

Recently, the Chinese have widened the daily trading band of the yuan, apparently under pressure from Capitol Hill to “do more”. However I believe that the gradual appreciation of yuan, instead of a rapid change, is better for the global economy in general and the US economy in particular. I will try to make my point in the following paragraphs.

Historically, currencies were evolved to replace the barter system, which was more difficult. Currencies kept working well until some “wise men” in central banks around the world “figured out” that instead of improving the real economy they could issue more bank notes and increase the cash flow to keep the illusion of development and appreciation.

The US dollar, and more recently the euro and to some extent other Western currencies, have been the main trading medium in international trade. For example, if India need oil from Saudi Arabia it will have to buy dollars first and then get oil. Again if Saudi Arabia wants to buy clothes for its public it has to use those dollars to buy clothes from China. The point is that one of the major strengths of dollar is that it is being used as an exchange currency between other non-US countries, especially third world countries. The United States benefits greatly from the fact that the dollar is the world's reserve currency. Dollars issued from the Federal Reserve and pumped into the global economy to buy goods and services are essentially a commitment to provide goods and services in return. However, most of the dollars are used by other countries to buy goods and services elsewhere and many of those dollars issued never return to the US to be redeemed for anything we make or produce. However, for the past few years the dollar has been on a downhill course. The dollar's erosion against the world’s other currencies shows no sign of ending for last several years.

Until recently “dollar” was the darling of central banks, companies, and individuals. It has been until recently stable. It is liquid and easily convertible. The dollar is still to a lesser extent currency of choice for global economy e.g. the money that changes hands through checks or wire transfers. The dollar is still the cornerstone of enormous cash economy as well. From tourists to traders, from dictators to drug dealers it has been the currency of choice who love to keep it in their valets or bank accounts. The Federal Reserve estimates, that "between 55% and 70% of outstanding U.S. currency notes circulates outside the US."

No, keeping in consideration the above background, consider the scenario that China is under pressure from the US to free float its currency and decide to accept the Yuan for trading since it will be freely exchangeable. In that case, the yuan will quickly appreciate to uncharted territories, maybe in days or weeks or months or few years. It will greatly diminish the status of the US dollar as “King of Reserve currencies”. Muscular yuan will be competing against the dollar for enormous cash economy from tourists to traders, from dictators to drug dealers. Furthermore central banks around the world will reallocate bigger share for yuan. This will happen at the cost of selling dollars, resulting in declining the dollar value quickly. This will automatically reduce the purchase of dollar by other countries.

In an earlier article I argued that China has became the manufacturing engine of global economy. Therefore, the secondary effect of the above scenario will be that prices of the goods manufactured outside the US will go up quickly. It may stimulate the local goods and services within US to some extent, however I will argue that the quick erosion of the US Currency as a world reserve currency will be far more damaging for the economy than the benefit of stimulation of some local manufacturing. The US will have to provide the goods and services for every dollar it has issued in the past or will issue in the future. This will be on top of loss of confidence in the currency.

The main losers of the quick appreciation of the yuan compared to dollar will be wage earner “John Does” with no savings. As far as the investors are concerned most of them have been reallocating their investments to different global regions including Europe, Asia and South America for the past several years and are well positioned to benefit from the dollar decline. Their assets value will increase inversely as the value of the dollar will decline. On the other hand, gradual appreciation of the yuan will give enough time for the economy to adjust and in this case the impact on ordinary US citizens will be minimized.

Individual investors could consider diversifying some of their investments to various world regions besides investing in US stocks and mutual funds in order to protect their investments, e.g. EUROX can provide exposure to Eastern Europe, FLATX to South America, OBCHX to China, DREGX, UMEMX, UUPIX to emerging markets and OBIOX to global stock markets.

Comments

[youderian]

Interesting article, although I'm suspect of Mohammad's claim that the majority of U.S. investor's will see an inverse relationship between their investments and the dollar. For that to hold true, the average investor would have to have over 50% of their portfolio in non-dollar denominated assets (i.e. commodities, foreign equities, etc.) While commodities and emerging markets have had been the life of the party recently, I doubt they make up the majority of the average American's investment portfolio.