Inflationary Implications of the Yuan/Dollar Currency Realignment

In my final Macroeconomics lecture given in May 2009 (I was on sabbatical this year) I predicted that this global debt crisis will be "solved" by a substantial inflation beginning in three to five years.

Now that a year has passed I can restate that I believe that we will see a few years of double-digit inflation within, now, two to four years. Some of the reasons I stated can be found by looking at the final few slides of that presentation, found here.

The European austerity programs that are now emerging in countries like Greece and Spain and will eventually be necessary in most other European nations, won't work. In the short run they will make the recession worse and are politically unpopular.

In the United States our annual budget deficits are so huge (around $2 trillion) and the prospects for reducing them so bleak, especially politically, that we collectively refuse to address the issue at any level. Essentially we are Portugal without a plan and without any recognition that we need a plan (or more accurately, without admitting that no plan is possible). In fact it appears this year that federal budget reconciliation, which normally takes place about now and is required by law will not even be attempted for the first time in our history.

The Chinese Contribution

The decision announced by the People's Bank of China over the weekend to effectively appreciate the Yuan relative to the Dollar will help contribute to the first leg of this inflationary impulse.

(The PCB press release actually said "... the People´s Bank of China has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility," but that clearly implies allowing the Yuan to appreciate manageably against the Dollar. In effect they are returning to the managed currency policies of the years indicated on the graph).

The recent history of the exchange rate is shown in the graph and is currently at 6.8275 Yuan to the Dollar.

Although it is yet unclear when and to what degree the Chinese government allow the exchange rate to drift, it is going lower on net. The PCB has made it clear that if the Dollar strengthens substantially as it recently did versus the Euro, then the Yuan may be temporarily devalued relative to the Dollar (but appreciated relative to the Euro), but none of this makes sense unless the exchange rate above falls.

This implies of course that the Dollar cost of goods and services manufactured in China and sold in the United States will rise. For example, if the Dollar devalues from its current level to, say, 6.00, that would be a devaluation of about 14%, and although collapsing margins could absorb some of this, prices of imported goods from China would likely rise by at least double digits.

The Size of the Chinese Trade

How important is the Chinese trade?

In 2009 in we imported $297 billion worth of merchandise goods alone (while exporting only $70 billion), down from $339 billion in 2008 but recovering in 2010. That only nets to 2% of GDP but is a much higher percentage of discretionary outlays by lower income consumers (the WalMart shoppers).

By itself it is not enough to turn a period of price stability into a galloping inflation but it will probably be remembered as one of the early catalysts.

In an earlier blog I suggested, without much evidence, that some speculation in the United States, including the creeping bull market that ended a few weeks back, was partly financed by a new Chinese carry trade. I still believed that happened. This currency realignment would damage any such carry trade and makes its continuation unlikely. Although the Chinese carry trade is initiated with U.S. Dollars (the first step does not require the conversion of Yuan to Dollars), the Yuan-value of the proceeds of such trade plunges as the currency plunges. Therefore, if I am right about the presence of a Chinese carry trade during the creeping bull market, it's removal now is bearish for the U.S. equity market.