Floating Yuan, Bullish Dollar?

Several months back, I discussed the possibility that letting the Chinese currency rise to its perceived level of "strength" versus the U.S. dollar could, just could, actually be dollar bullish. How? Right now, Chinese capital is locked up in yuan. Yet give Chinese savers a choice, let them choose what currency they want to own, and is it possible they could bolt, en masse, out of their own currency and into dollars? Well, yes, it IS possible. It would reflect a general lack of confidence in the Chinese banking system. The currency would gain in purchasing power overnight, but that might not be enough to correct a local perception that it's still just paper, plagued by bad debts. Of course, I don't know what the local perception is. And that's one reason I'm going to China, to see just what the Chinese think of the dollar and gold. For now, the Chairman (Alan Greenspan) recognizes that a floating yuan might not be all good for China. In a written response to questions from Senator Richard Shelby, published in yesterday's WSJ, Greenspan articulated the threat. You can find another brief article on it in the Asia Business Times. Click here. "With a US presidential election looming, outsourcing by US companies to manufacturers in China is a politically sensitive issue, as is the general problem of the US balance of payments deficit. "Mr Shelby had asked Mr Greenspan to elaborate on a speech he had made in December arguing that the Chinese policy of pegging the yuan against the dollar risked causing inflation and eventually a recession in China. "Mr Greenspan said in his reply that China, before floating the yuan, had to tighten regulation of the banking system and its accounting practices and also had to provide them with government capital so that they had reserves for bad loans. 'More important, however, are steps that eliminate state interference in bank lending decisions and that create the financial discipline and incentives that are a crucial part of a viable credit system. " One of the underappreciated--and more boring--aspects of the balance of payments deficit is what a foreign central bank does with all the dollars it accumulates. It's understood that a central bank, like Japan's for instance, sells its own currency, and then buys dollars--effectively keeping a lid on its own currency's strength. But once its got those dollars, it can either keep buying U.S. bonds...or start to seek other outlets. After all, if you're buying billions of dollars worth of dollars...you're taking on a lot of risk owning, and beginning to control, a large corner of the U.S. bond market. Asian central banks are looking for other things to do with their dollars, and those things may finally be causing inflation...creating mini asset bubbles wherever excess capital flows get directed. Two weeks ago, I asked my friend Greg Weldon about this and he said: More interesting, going forward ... is the recent SPIKE in official FX reserves in places like Korea and China, who have recently loosened regulations related to 'active-management' by privately owned firms, OF those reserve pools. Indeed, today ... Korea followed the 'lead' of China, using USD reserves (up HUGE in first two weeks of Feb) to directly purchase USD-priced commodities, as raw materials for local manufacturers, to help reduce the pressure on export margins !!!! Copper is specifically higher today, in my view, on this little noted story. Danger is all around, the land mines are active and the field is strewn !!! Interesting new relationship to watch for: foreign currency reserves and sudden changes in commodity prices. The inflation trade is on...although through perverse back channels...driven by too many dollars chasing too few assets to invest it. Obviously, what the world needs are more assets to invest it. That way, the boom in dollars can go on forever, and not cause any single bubble to get unsustainable.