Breaking the Peg
Billmon - Whiskey Bar
July 22, 2005
billmon.org
I got so caught up in other matters yesterday that I completely ignored the big financial news: the Chinese government finally bowed to reality and adjusted the rigid peg that fixed the value of its currency, the yuan, against the U.S. dollar.
This is, at least potentially a very big deal -- for reasons which I've been talking about, off and on, almost since I first opened Whiskey Bar. While the financial market reaction to today's move was, all things considered, relatively mild, there's no guarantee that will remain true going forward.
It's possible, in fact, that we have just passed a major milestone in economic history -- and in the much briefer history of America's reign as the world's only superpower. But this may not be recognized for many years to come.
The People's Bank of China did two things yesterday -- it revalued the yuan by a little more than 2% against the dollar (and derivatively, against every other currency) and it shifted from a straight dollar peg to a basket of currencies, including both the Japanese yen (Japan is China's major creditor) and the euro (Europe is China's second largest trading partner.)
The net effect of these moves was rather modest -- more modest than was expected. A 2% revaluation isn't likely to make much of a dent in China's enormous trade surplus with the United States. Nor is it likely to shrink the Yangtze sized river of speculative hot money that's been pouring into China for the past two years. In fact, for reasons to be explained later, it may make those flows even larger.
The shift to a currency basket will also have relatively little practical effect at first, although over time it should induce the People's Bank to significantly diversify its foreign reserve holdings. This, in turn, will tend to curb the bank's voracious demand for dollar paper assets, such as Treasury bonds. All other things being equal, this could push U.S. long term interest rates considerably higher, putting a major crimp in America's ability to go on spending itself into bankruptcy on the installment plan.
More immediately, though, China's move puts pressure on other energing Asian countries to allow their currencies to rise against the dollar, which Malaysia did as soon as it heard the news from Beijing. Hong Kong, which is now an appendage of the mainland economy, soon will have no choice but to do likewise, although for now its still holding out.
As Asian currencies are freed to float, other Asian currenies, already floating, become freer to rise. Their central banks, too, will now have less reason to purchase dollar assets, adding to the pressure on U.S. bond yields (which, in the fullness of time, shoud also translate into higher mortgage rates. The housing bubble has been living on borrowed time, and now the first of those loans are coming due.)
Bond traders, knowing all this, have already started bidding bond prices lower and yields higher. The yield on the benchmark 10-year Treasury note rose from 4.18% to 4.28% yesterday -- a pretty sizable daily jump, although frankly not as much as I would have predicted.
That may be because the market had already gotten wind of the revaluation. Yields have moved up substantially over the past few weeks. Also, the London bombing caused a brief run back into Treasuries yesterday morning. Federal government securities are widely viewed as a safe haven in times of crisis. So we may see some more selling today or Monday.
The U.S. stock market also traded lower on the news, although not dramatically so. Asian stocks took the news much harder -- which only highlights the deflationary undertone to the global economy, high oil prices notwithstanding.
What the financial markets are saying, in other words, is that right now a weaker dollar is worse news for Asian exporters than it is for U.S. consumers. If global goods and services markets were tighter, if producers had more pricing power, they'd be telling us the opposite.
The underlying problem, however, is that the financial imbalances required to match massive U.S. current account deficits with equally massive Asian surpluses are becoming progressively less sustainable.
In that sense, China's revaluation probably marks the beginning of the end for Bretton Woods II -- the highly inappropriate name given to these imbalances by a couple of conservative economists, who want to pretend that some kind of formal system exists for channeling Asian savings to American borrowers.
But there is no such system -- unlike Bretton Woods I, which was backed by a treaty, by formal rules for revaluations and devaluations, and by institutions (the IMF and the World Bank) designed to help member countries absorb some of the stresses and strains of fixed exchange rates.
BW II has none of those things -- although it may have to acquire them if it wants to live much longer. But BW II does one thing in common with BW I. It, too is anchored by a single country. Only this time, the key player isn't the United States, but China.
Up until yesterday, the People's Bank had shown an almost unlimited willingness to buy dollars to maintain the yuan peg -- thus mopping up whatever dollars America's other Asian creditors, including Japan, didn't want to hold. This encouraged other emerging countries to stay in the "system," since they knew China wouldn't allow the dollar to fall too far, protecting them from big losses on their reservess.
This is the classic swing role played by the central player in any successful cartel. Thus my nickname for the People's Bank -- "the Saudi Arabia of money."
But the "Saudis" have just signaled that their ability to stabilize the market has reached its limits -- or, more precisely, that domestic economic considerations (and/or a desire to avoid U.S. trade sanctions) now outweigh the importance of stabilizing the market.
Without China as the backstop, though, the other members of the cartel would have less incentive to hold dollars -- and, logically, a greater fear that they would be left holding the bag if China eventually allowed a much bigger decline in the dollar. The lonnger these smaller players wait to diversify their reserves, the greater the risk that others will do it first, quietly or covertly, leaving them with heaviest losses. The classic "prisoner's dilemma."
They BW II nations also have to worry about the outside players, such as Russia and the gulf oil states, who also are accumulating huge dollar reserves but who are not plugged as deeply into the cartel.
There are, of course, countervailing pressures to resist revaluation -- from Asian exporters who don't want to give up their price advantage, Asian central bankers who fear financial instabilty, and Asian politicians who fear slower growth and unemployment. BW II may be doomed, but that doesn't mean it will die quickly.
In fact, the short-term impact of China's decision may be to cause more, not less, speculative hot money to flow into the Asian countries, particularly the People's Republic.
The global hedge fund class could easily assume that further Asian currency moves (all of them upwards) are in the offing, creating the lure of quick and easy profits. This could force Asian central banks to buy even more dollars to stave off the speculators -- thus creating an exact mirror image of the Asian financial crisis of the late '90s. Since the bulk of the purchased dollars would probably find their way back into the U.S.bond market, yields could decline again -- no doubt prompting the "deficits don't matter" brigade to write the whole thing off as a phony crisis.
They might even be right -- at least for awhile. In addition to revaluing the yuan, China also announced yesterday that it will loosen controls on capital outflows. This could encourage private Chinese investors to buy more U.S. dollar assets, easing some of the pressure on the People's Bank to mop up all that speculative hot money flowing in. Chinese investors would do it for them, helping to put BW II on a firmer foundation.
It could happen. But the smart money says it won't. Now that China has made the first move, expectations of further yuan appreciation are likely to become self-reinforcing. Or, as economist Nouriel Roubini puts it:
With the currency move today there is now a greater likelihood that the Chinese currency will further appreciate over time. Thus, international traders and investors . . . will have an even greater incentive to bring capital into China to obtain large capital gains once the Chinese currency moves even further. So, liberalization of capital outflows won't help in the short run, as capital is going only one way today -- into China rather than out of China.
Those kind of one-way streets are also an invitation to market volatility and overshooting, meaning the dollar could end up tanking against all the major Asian currencies, triggering big losses in the U.S. stock and bond markets. BW II could come tumbling down in a hurry -- triggering recessions in the U.S. and probably the global economy as well. This is the famous "hard landing," which would force a very quick, very painful reduction in U.S. living standards.
But the more likely scenario, given the deflationary dynamics, is that the players will find some way to keep Humpty Dumpty from falling off his wall entirely. China will resist a too rapid depreciation of the dollar, gradually restoring confidence in its role as the anchor of the cartel. The system will stagger on -- until the next crisis, which almost certainly will be worse.
There is precedent for this. Bretton Woods didn't die overnight. It unraveled over a ten-year period, starting with the formation of the central bank Gold Pool in 1961 (allowing the BW I cartel to manipulate the price of gold), followed by the creation of a "two-tiered" reserve system in 1968, and culminating in Nixon's dramatic decision to close the gold window entirely in 1971.
None of these moves were seen at the time as the end -- or even the beginning of the end -- of Bretton Woods I. Even the decision to close the gold window (effectively smashing the dollar-gold link at the heart of the system) wasn't designed to be permanent. Efforts to patch things up continued until 1973.
Likewise, investors didn't regard the death of Bretton Woods I as a financial Armaggedon -- at least not at first. The stock market soared after Nixon closed the gold window, on the (correct) expectation that it would free the Fed to drop interest rates and rev up the economy.
It was only later, after the longer-term consequences of the collapse of BW I became obvious -- in the form of oil shocks, massive inflation and financial instability on a grand scale -- that the markets freaked, bringing on the worst bear market, and the deepest economic slump, since the Great Depression.
I don't know exactly where we stand in the decline and fall of Bretton Woods II. Nobody does. But I would interpret yesterday's news as an early warning that the system isn't sustainable in its present form. If history is any gude, the stop-gap solution that emerges will have an even shorter shelf life.
The factors that have allowed the United States to run enormous, sustained current acount deficits -- deflation, globalization, the Asian savings glut -- may persist for some time. But sooner or later, the sheer size of America's external liabilities is going to force foreign creditors to limit their exposure to our reckless financial behavior. Solvency, not relative rates of return, will be the issue on their minds then.
BW II only postpones the day; it can't prevent it. By allowing America to go steadily deeper into debt, it also makes the day's arrival more certain and more dangerous. And by modifying the dollar peg -- even if only slightly -- China has set the clock in motion. |
