Why China’s Currency Peg Can’t Last

Broken ice or glass with a flag pattern, China

China is understanding there are limits to monetary policy…especially after an historic credit boom. Bloomberg reports:

Is China’s latest monetary easing really going to help? While economists see it freeing up about 600 billion yuan ($96 billion), that assumes businesses and consumers want to borrow.

This chart may put some champagne corks back in. It shows demand for credit is waning even as money supply continues its steady climb.

The reserve ratio requirement cut "helps to raise loan supply, but loan demand may remain weak,” said Zhang Zhiwei, chief China economist at Deutsche Bank AG in Hong Kong. "We think the impact on the real economy is positive, but it is not enough to stabilize the economy.’

"Monetary stimulus of the real economy has not worked for several years," said Derek Scissors, a scholar at the American Enterprises Institute in Washington who focuses on Asia economics. "The obsession with monetary policy is a problem around the world, but only China has a money supply of $20 trillion.”

The problem China faces is only made worse by its peg to the US dollar. The last thing China needs is a strengthening currency. This erodes its export competitiveness against nations like Japan and South Korea.

At some point, I think China’s leadership will break the currency peg with the US dollar before the peg breaks them. This might be good for China, but it doesn’t bode well for the rest of the world. It will represent another crack in the global monetary system.

Late last week, the UK Telegraph painted an alarming picture of the effects of a potential yuan devaluation:

If this were to happen, it would send a deflationary impulse worldwide. China spent $5 trillion on fixed investment last year, more than Europe and America combined, increasing its overcapacity in everything from shipping to steels, chemicals and solar panels, to even more unmanageable levels.

A yuan devaluation would dump this on everybody else. It would come at a moment when Europe is already in deflation at -0.6pc, and when Britain and the US are fast exhausting their inflation buffers as well.

Such a shock would be extremely hard to combat. Interest rates are already zero across the developed world. Five-year bond yields are negative in six European countries. The 10-year Bund has dropped to 0.31. These are no longer just 14th century lows. They are unprecedented.

There are a lot of ‘unprecedented’ events going on in markets right now. It is this bewilderment and confusion that’s behind the ‘lack of confidence’ that seems to permeate many societies around the world.

We’re going to need a lot more than lower interest rates to get us out of the hole we’ve dug for ourselves over the past few decades.

The moment hath cometh to get out of the hole…or at least it’s surely on its way. But has anyone seen the man?


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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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