Background:
On the 23rd of March 2009, a top functionary from the People's Bank of China, named Zhou Xiaochuan, made a forthright appeal for the reformation of the international monetary system.
His assertions—given the strong ties that the People's Bank of China has with the Chinese government—leave one with the indelible impression that the Chinese establishment is currently alarmed by the prospect of economic pandemonium materializing in China - owing to the continued use of the U.S. dollar as the international reserve currency.
In his speech, Mr. Xiaochuan enunciated that the international reserve currency should be super-sovereign (read: 'disconnected from economic conditions and sovereign interests of any single nation'), to insulate the densely-interconnected global economy from its vulnerability to the contagion effect (which is a systemic risk).
Furthermore, he suggested that it would be prudent to award Special Drawing Rights (SDRs) the role of a super-sovereign reserve currency, because their features are identical to the theoretically-depicted features of a super-sovereign reserve currency, which include: 1) Disconnection from the economic conditions and sovereign interests of any single country; 2) The ability to remain durable in the long-run, and; 3) Multi-territorial integrity.
Succinctly expressed: Mr. Xiaochuan is subtly petitioning the International Monetary Fund (IMF) to abandon the usage of the U.S. dollar as the international reserve currency, and to instead adopt Special Drawing Rights (SDRs) as a super-sovereign reserve currency.
Evidently, his proposal is underpinned by the following line of reasoning: "The U.S. is currently teetering on the brink of a protracted recession because of the credit crisis it has endured since 2007. Thus, the continued usage of the U.S. dollar as the international reserve currency is tantamount to globalization of the U.S.'s economic woes."
Currently, there is a crescendo of echoes of this line of reasoning emanating from different parts of the globe, and this may culminate in unequivocal remonstrations (against the usage of the U.S. dollar as the international reserve currency) during forthcoming IMF-organized events.
Introduction:
My aim in writing this commentary, is to explore a dystopian scenario that could materialize in China if an unstable U.S. dollar maintains its status as the international reserve currency: I'm going to be exploring the Finagle's Law scenario - where anything that can go wrong, goes wrong—at the worst possible moment.
Currently, China's currency, like that of Dubai, is fixed to the U.S. Dollar, that is; China has a fixed nominal exchange rate policy. What this simply means is that x dollars will always translate into y yuan regardless of changes in China's macro economic stamina.
Therefore, this implies that the health of the Chinese yuan is tied to that of the U.S. dollar.
Finagle's Law Scenario:
Let us postulate the Finagle's Law scenario, where anything that can go wrong goes wrong—at the worst possible moment, or where the perversity of the Universe tends towards a maximum;
It is now December 2009, and the U.S. economic crisis has become more acute. This has caused the U.S. dollar's fiat value to plummet in terms of other currencies. Hence, since the Chinese yuan's nominal value is fixed to that of the U.S. dollar, it becomes more grossly undervalued, ceteris paribus, with respect to the U.S. dollar than it was in the past.
Therefore, because of this, speculators are increasingly selling their dollars to accumulate undervalued yuan, resulting in excess demand for Chinese yuan. (Why? Because if two different currencies trade at a fixed exchange rate and one currency is undervalued with respect to the other, the undervalued currency will be in excess demand).
Thus, China is faced with two choices to: either increase the supplies of the yuan to meet the excess demand, or; adjust the par value of the yuan upward enough to eliminate the excess demand.
Obviously, the Chinese government has a marked preference for the former.
Therefore, the Chinese government, in a bid to relieve the upward pressure on the par value of the yuan with respect to the U.S. dollar, decides to intervene in the foreign exchange markets by buying dollars with yuan. This causes an automatic increase in the supply of the yuan to take place, and the real relative value of the yuan falls, albeit temporarily.
Unfortunately, this makes the yuan even more attractive to speculators, who now demand even more yuan (as they'll perceive the yuan to be more acutely undervalued than it was before the intervention). This triggers another similar intervention (i.e. buying dollars with yuan) by the Chinese monetary authorities, which starts the fruitless cycle again.
Eventually, the Chinese government is forced to adjust the value of the yuan upwards enough to eliminate the excess demand for the currency. However, this move would, in essence, threaten China's current account surplus; as Chinese exports would become more expensive because of this (which means that international demand for them would fall).
Clearly, this would have adverse effects on China's hyper-aggressive economic growth rate and its clout in the global political arena (because international political power has a direct positive correlation to a nation's economic fortunes).
Conclusion:
The Finagle's Law scenario simply illustrates that China's exchange rate management policy is only sustainable when the U.S. is experiencing 'normal' or extraordinary economic growth. Whenever the U.S. is in a state of economic turmoil, China experiences extreme pressure to adjust the value of its currency upwards (with respect to the U.S. dollar).
Hence, China's calls for a super-sovereign currency simply mean that the country is desperately looking for a permanently stable currency to fix the value of the yuan to. If the value of the yuan were to be fixed to a super-sovereign currency, China would have immunity from market-pressures to adjust the value of its currency upwards (with respect to credit-based reserve currencies): something that is evidently, in China's best interests.
On the 23rd of March 2009, a top functionary from the People's Bank of China, named Zhou Xiaochuan, made a forthright appeal for the reformation of the international monetary system.
His assertions—given the strong ties that the People's Bank of China has with the Chinese government—leave one with the indelible impression that the Chinese establishment is currently alarmed by the prospect of economic pandemonium materializing in China - owing to the continued use of the U.S. dollar as the international reserve currency.
In his speech, Mr. Xiaochuan enunciated that the international reserve currency should be super-sovereign (read: 'disconnected from economic conditions and sovereign interests of any single nation'), to insulate the densely-interconnected global economy from its vulnerability to the contagion effect (which is a systemic risk).
Furthermore, he suggested that it would be prudent to award Special Drawing Rights (SDRs) the role of a super-sovereign reserve currency, because their features are identical to the theoretically-depicted features of a super-sovereign reserve currency, which include: 1) Disconnection from the economic conditions and sovereign interests of any single country; 2) The ability to remain durable in the long-run, and; 3) Multi-territorial integrity.
Succinctly expressed: Mr. Xiaochuan is subtly petitioning the International Monetary Fund (IMF) to abandon the usage of the U.S. dollar as the international reserve currency, and to instead adopt Special Drawing Rights (SDRs) as a super-sovereign reserve currency.
Evidently, his proposal is underpinned by the following line of reasoning: "The U.S. is currently teetering on the brink of a protracted recession because of the credit crisis it has endured since 2007. Thus, the continued usage of the U.S. dollar as the international reserve currency is tantamount to globalization of the U.S.'s economic woes."
Currently, there is a crescendo of echoes of this line of reasoning emanating from different parts of the globe, and this may culminate in unequivocal remonstrations (against the usage of the U.S. dollar as the international reserve currency) during forthcoming IMF-organized events.
Introduction:
My aim in writing this commentary, is to explore a dystopian scenario that could materialize in China if an unstable U.S. dollar maintains its status as the international reserve currency: I'm going to be exploring the Finagle's Law scenario - where anything that can go wrong, goes wrong—at the worst possible moment.
*****
Currently, China's currency, like that of Dubai, is fixed to the U.S. Dollar, that is; China has a fixed nominal exchange rate policy. What this simply means is that x dollars will always translate into y yuan regardless of changes in China's macro economic stamina.
Therefore, this implies that the health of the Chinese yuan is tied to that of the U.S. dollar.
Finagle's Law Scenario:
Let us postulate the Finagle's Law scenario, where anything that can go wrong goes wrong—at the worst possible moment, or where the perversity of the Universe tends towards a maximum;
It is now December 2009, and the U.S. economic crisis has become more acute. This has caused the U.S. dollar's fiat value to plummet in terms of other currencies. Hence, since the Chinese yuan's nominal value is fixed to that of the U.S. dollar, it becomes more grossly undervalued, ceteris paribus, with respect to the U.S. dollar than it was in the past.
Therefore, because of this, speculators are increasingly selling their dollars to accumulate undervalued yuan, resulting in excess demand for Chinese yuan. (Why? Because if two different currencies trade at a fixed exchange rate and one currency is undervalued with respect to the other, the undervalued currency will be in excess demand).
Thus, China is faced with two choices to: either increase the supplies of the yuan to meet the excess demand, or; adjust the par value of the yuan upward enough to eliminate the excess demand.
Obviously, the Chinese government has a marked preference for the former.
Therefore, the Chinese government, in a bid to relieve the upward pressure on the par value of the yuan with respect to the U.S. dollar, decides to intervene in the foreign exchange markets by buying dollars with yuan. This causes an automatic increase in the supply of the yuan to take place, and the real relative value of the yuan falls, albeit temporarily.
Unfortunately, this makes the yuan even more attractive to speculators, who now demand even more yuan (as they'll perceive the yuan to be more acutely undervalued than it was before the intervention). This triggers another similar intervention (i.e. buying dollars with yuan) by the Chinese monetary authorities, which starts the fruitless cycle again.
Eventually, the Chinese government is forced to adjust the value of the yuan upwards enough to eliminate the excess demand for the currency. However, this move would, in essence, threaten China's current account surplus; as Chinese exports would become more expensive because of this (which means that international demand for them would fall).
Clearly, this would have adverse effects on China's hyper-aggressive economic growth rate and its clout in the global political arena (because international political power has a direct positive correlation to a nation's economic fortunes).
Conclusion:
The Finagle's Law scenario simply illustrates that China's exchange rate management policy is only sustainable when the U.S. is experiencing 'normal' or extraordinary economic growth. Whenever the U.S. is in a state of economic turmoil, China experiences extreme pressure to adjust the value of its currency upwards (with respect to the U.S. dollar).
Hence, China's calls for a super-sovereign currency simply mean that the country is desperately looking for a permanently stable currency to fix the value of the yuan to. If the value of the yuan were to be fixed to a super-sovereign currency, China would have immunity from market-pressures to adjust the value of its currency upwards (with respect to credit-based reserve currencies): something that is evidently, in China's best interests.
