Global economics is a dynamic subject, unfortunately without any reference.

The only reference one has is the market. The reference system of something tangible was closed down with the closing of the Bretton Woods system when the gold window was closed by the Nixon-administration (Nixon-Shock) back in 1971, unilaterally.

Back then every other currency was re-evaluated with the dollar on a periodic basis, and the dollar was pegged with gold at a constant rate. It is another matter that works of economists showed why such a system was designed to fail, without devaluing dollar (Triffin dilemma) or affecting the domestic economy.

Leaving things at the hands of markets has its shortcomings, as very recently the world witnessed how wrong the markets can be. My personal opinion is not so although, I still believe in markets and market forces. However systematical rigging by central bankers and institutional investors have left markets at the mercy of a few, mostly from the Wall Street and from the Federal Reserve, and their counterparts from other countries. So what I would like to believe by market and market forces is much different from what the (financial) world believes as market (the Wall Street, Fed and their equivalent).

The biggest difference is on supply and cost of money itself, by which markets are all measured. In my definition of market, one must have some certainties on these two, more so when there is no constant reference. The only floating references we have is few major global currencies.

Asset classes has lately been moving not based on fundamentals of the asset class demand and supply, but on supply and its cost of major global currencies. So if Zimbabwe prints a lot of money (increase money supply), that does not affect global asset prices barring that in Zimbabwe; but when same is done by the Fed., the Bank of Japan or by the ECB; it affects global asset prices. And when they all do it together with most other central bankers; it’s party time for asset classes.

At the same time, all over the world, without any referencing system for exchange, money is all relative. When someone says that the temperature is so much, or the distance is so much, one understands that figure. It remains same without matters of interpretation, in the US or in China. But when one says that manufacturing cost of steel pipes in the US is around $1500/ton whereas same in China is $1200 or around (assuming this is true under certain accepted conditions), one obviously does not lead to the conclusion that Chinese steel pipe producers have cost competitiveness. The reason of the price difference can be manifold: major of which are (1) there is hidden subsidies in China’s cost and/or (2) China’s currency is undervalued, meaning if the cost in China is $1200/ton and $:Yuan is at 6.80; in China, actually the cost is 8160 Chinese Yuan. Now assuming Yuan is undervalued and a better valuation will be 5:1 to the US dollar, 8160 Yuan translates into $1632/ton of steel pipes. And thereby China loses the cost competitiveness.

Question thereby remains: what’s the right value of Chinese yuan?

And that’s been the most important debate in economics lately. It even attracted views from Krugman and Mohamed El-Erian and Ramin Toloui of PIMCO. Unfortunately, no single satisfactory answer can emerge from the debate.

Unlike major other countries, who have sort of a market-determined exchange rate – China follows a pegged exchange rate. At times they allow a predetermined band-movement, and there are times when not even that small band movement is allowed. Chinese currency is effectively pegged with the dollar. The dollar strengthens, Yuan strengthens (that’s what happened at the peak of crisis in 2008); and when dollar weakens – Yuan also weakens by same degree – relative to all other currency. When one compares Yuan with other currencies like Korean Won or Indian Rupee over last two years, one finds Yuan to have appreciated more against dollar. In spite of that, the cries to allow faster appreciation of Yuan get louder by the day.

But lately dollar is declining, and it’s declining fast. It’s yet to reach its bottom when one euro could get 1.5990 dollar in July last year, however that point is probably getting nearer. The trigger no doubt is the unemployment figures in the US.

The majority view has lately and surprisingly been to allow Yuan to appreciate against dollar. This school of thought believes that by doing so we can help (1) the world economy in self-correcting much of the economic imbalances, (2) would help the US to recover faster, and (3) would help China too by increasing its domestic demand than relying on exports for the much needed growth in GDP or employment generation or poverty reduction.

However I remain confused in understanding how exactly it helps. And what should be the priority – the world fast (and again what part of the world – reducing poverty or increasing global GDP). It could have been easier if someone could form an objective function, satisfying all stakeholders around the world, with orders of priorities with maximization/minimization goals with realistic constraints. If one recollects the story of Japan and how Japan has been struggling since the time yen was allowed to appreciate against 350 or more to a dollar to less than a hundred, one understands the gravity of the problem.

One school of economists often state that there’s been no example globally that a country could prosper economically by devaluing its currency. And that’s what many now recommend for the US recovery! And if a ‘strong dollar’ is indeed good for the US and the rest of the world, the Chinese Yuan, pegged to the weak dollar, is actually helping the dollar get some badly needed relative strength against the other currencies.

Let’s consider impact on global GDP. If Yuan is allowed to appreciate, dollar devalues further and faster. China loses its valuation of dollar reserves and its export competitiveness as we saw with the example of steel pipes. Chinese GDP itself soars when measured in $, and so does for other nations. So the global GDP increases – because dollar goes down and everything else is measured in dollar. But if same GDP was measured in Yuan (or Euro), we might not have seen significant change (rather it may go down as US GDP shrinks more when measures against appreciated Yuan). So the net gain is only in terms of units of measure and nothing much in reality.

My top priority being poverty reduction and employment generation – globally, how does Yuan appreciation impact these two?

To address above, there is no denying that in the longer term, Yuan will appreciate. However present question is how fast that should be. China wants to do it at a much slower rate than what the US would love to see.

So if Yuan is allowed to appreciate faster, following scenarios may happen:

  1. As global experts suggest, domestic demand picks up in China at same rate to offset loss in exports, thereby no tangible loss in employment or in poverty reduction. Or is it? China losses its rate of increase of forex reserves; thereby reducing Chinese government power to spend money on developmental goals. So employment may remain same, however on poverty in China, it is likely to have a negative impact. True, Chinese people – when traveling abroad, would feel richer.
  2. At the same time, there is more job creation (and poverty reduction) in the US and in other exporting countries. It essentially means a win-win situation as overall demand grows globally.
  3. The environment suffers.

So under this scenario, there is little loss to China, but overall rest of the world gains. Surely, the gains look likely to be more than the losses.

However what’s the probability that domestic demand in China indeed moves at an equal rate to offset the loss in exports, when Yuan is allowed to appreciate at a rate that would please the Obama-administration.

In the longer term, I see it possible; however gauging the expectations of rate of Yuan appreciation that policy-makers in the US would love to see, I see potential problems in China. So that’s the alternate scenario, and China may suffer a lot by undertaking that experiment now.

China will not be able to increase its domestic demand fast enough to allow faster Yuan appreciation to please the west. And if that happens once; it may take back China by years.

I am sure if it was any other country under same circumstances, they would have done the same as China’s been doing. It’s the only prudent decision they can take, keeping in mind the journey that they had over the last decade.

Much of China story today looks so bright because of their management of the currency. If something has been working well for them for long, why disturb it at a critical moment? At the same time, as China tests global acceptance of Yuan as a currency for settling bilateral trade, or for trade on crude oil; it will eventually be bound to allow Yuan to appreciate. And towards that effort, China has been trying not only to increase domestic demand within China, but also in other developing countries in Latin America and Africa.

Unfortunately the same medicine (exporting capital) is no longer working well for the US as it sees Wall-Street recovery without jobs recovery.

The all important question remains when and how the issue gets settled. In between China would claim that duties imposed on Chinese tyres or steel pipes would force US consumer to spend $400 more on each car and similar amount on steel pipes. And the US would claim otherwise.

Truth will be hidden somewhere in between. Back in 1971, the US Secretary of Treasury John Connolly of Nixon Administration told his European counterparts: the dollar is our currency but your problem. By pegging Yuan to the dollar, China has no doubt made the valuation of dollar a problem to the US itself.  

Ranjit Goswami is the author of the book, Wondering Man, Money & Go(l)d, and can be followed at Twitter.

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