October 10, 2003

The Yuan Gets Buoyant?

Hat-tip to 6’10 power-forward and macro-maven Greg Weldon for spotting a suspicious phrase in a statement from China’s Premier Wen Jiabo on the currency. Wen said: “The current unitary and managed floating exchange rate regime based on market demand and supply is in line with China’s reality. It shows China has a high sense of responsibility toward the international community.” Say what? What exactly is a “managed floating exchange rate regime.” I was under the impression China had pegged its currency to the dollar. A peg doesn’t float, it follows rigidly. So is China sending out signals that it’s willing to change its currency policy? Is China caving to the Bush administration? Hardly. Both Bush and China want an “orderly” decline in the dollar (and a stronger yuan), but for different reasons. China wants the revaluation of the yuan to be gradual. If there’s a run on the dollar, Chinese holdings of U.S. bonds get whacked. And the Chinese own a lot of U.S. bonds. How to engineer a lower dollar without causing a run on dollar-denominated assets? This is THE key question for U.S. monetary and fiscal policy makers. John Snow and George Bush want a weaker dollar so they can show a turnaround in U.S. trade numbers for the first and second quarter of next year--just in time to win the election. But the dollar can’t go too low too fast. The difference between an orderly retreat and full-scale rout could cost Bush the Presidency. One possible solution to a lower dollar that DOESN’T cause bonds to sell off (and yields to rise), is to direct Chinese and Japanese into buying agency securities (Fannie and Freddie bonds.) This keeps the flow of capital into dollar-denominated assets, which prevents the trade deficit from exploding even more…and gives a weaker dollar time to work it’s export-boosting magic (remember, this is the theory…in point of fact, the weaker dollar of the last twelve months has caused a whopping 1% of growth in export prices, while import prices have grown at 0.8%). Persuading foreign central banks to buy agency securities instead of Treasuries doesn’t exactly solve the U.S. federal government’s funding problems. But it might at least placate the market that there IS a market for Fannie and Freddie mortgage backed bonds--even as the ground beneath Fannie and Freddie starts to crumble. And instead of having the Japanese and Chinese buy bonds directly on the open market, the Fed can do what it did last week and buy U.S. bonds on behalf of foreign central banks. The bond market gets supported, the dollar weakens, and everyone is happy. Is this the secret plan to de-peg the yuan gradually without blowing up the dollar? We’ll see. For now, foreign investors, both central banks and private investors, are still scooping up U.S. bonds. Yesterday, the Fed reported that foreign holdings of Treasuries rose $16.94 billion last week to an all-time high of $798.67 billion. Foreigners added $1.30 billion in agency debt for a total of $193.10 billion. But after today’s trade numbers--and with the simmering trouble at Fannie and Freddie--don’t be surprised if the pace of machination picks up soon. And keep in mind, the list of governments that have engineered orderly transitions for an over- or undervalued currency….is so short…that it doesn’t exist.


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