An undervalued Yuan is frequently blamed for the consumption and credit bubble in the United States. The rationale for such an argument points to the triangular interdependency between US borrowing, US spending and Chinese lending.
The Yuan is pegged to the US dollar at an artificially low rate making Chinese exports especially attractive to US consumers. When US consumers buy Chinese goods the Chinese receive US dollars.
If the Chinese converted their US dollars into Yuan there would be upward pressure against their currency. To maintain the peg, the Chinese would need to print Yuan, which would exacerbate domestic inflationary pressures. Instead of converting those dollars to Yuan the Chinese recycle them back into US dollar-denominated assets. This reduces upward pressure on the Yuan, and has the secondary effect of providing an ample supply of cheap financing for US businesses and consumers.
This, of course, stimulates US borrowing and consumption, perpetuating the borrowing-consumption-lending cycle – a major contributor to the US bubble that has been bursting over the past couple years.
One solution to this vicious circle is to unpeg the Yuan allowing it to free float in the foreign exchange markets. Doing this would likely cause the Yuan to rise against the dollar, making Chinese exports less competitive.
Solutions are often the biggest causes of problems.
While a free-floating Yuan would help alleviate current imbalances, the Japanese experience of the 1980s may cause policy makers to think twice about such an action.
The 1985 Plaza Accord – an agreement between France, West Germany, Japan, the US and the UK to devalue the US dollar in relation to the Japanese Yen and German Deutche Mark – was enacted to help the US climb out of deep recession and reduce the US current account deficit. After the Plaza Accord was enacted, the US dollar subsequently depreciated about 50% against the Yen from 1985-1987.
An expensive Yen meant that Japan’s export-dependant economy became less competitive and began to slow. The Bank of Japan and Japan’s Ministry of Finance responded by increasing domestic monetary and fiscal stimulus. In an environment of low inflation and a rising Yen the Bank of Japan erred on the side of expansion, and loose monetary policy lasted from 1985 until 1989 fuelling a massive speculative rally in Japanese housing and share prices.
Speculation bred speculation. Everyone from international asset managers to Japanese students were drawn to the light of a rising Yen and Japanese asset prices. As with most speculative bubbles, Japan had its share of new paradigms, vicious cycles and gambling.
The Japanese bubble finally peaked in 1990 and was one of the biggest the world has ever seen. Unfortunately, its decline has been just as massive. During the 2008/2009 market crash (twenty years after the Japanese bubble burst), the Nikkei 225 Index reached levels not seen since the early 1980s.
If China were to follow in Japan’s footsteps by allowing the Yuan to free-float, would a similar catastrophe unfold? This is a fair forecast, since one would expect a dearer Yuan to slow Chinese exports, and Chinese authorities to loosen domestic monetary and fiscal policy in response to slowing GDP.
If China were to follow in Japan’s path, we might see the biggest bubble yet.
