Yuan Yuan Go Away
"The financial markets have essentially given up on a Chinese re-valuation. The non-deliverable forward market is pricing in only a 1.1% premium on one-year forward yuan. The market is pricing in a mere 3.3% premium to buy yuan five years forward. The economic reality is completely out of whack with this pricing. It is in the best interest of both China and the global economy to have a significant revaluation in the yuan sooner rather than later. The longer the Chinese wait, the graver the imbalances will be in both the Chinese economy and the world."
The Chinese government is using capital controls to keep their currency (yuan) pegged in valuation to the dollar. This by necessity means that Chinese interest rates are being kept in line with U.S. interest rates. Because the Chinese economy is stronger than the U.S. economy, there are consequently more capital needs and Chinese businesses would gladly pay higher interest rates than they do for it. In other words then, rates are artificially low in China relative to U.S. interest rates (which themselves are artificially low thanks to the Japanese).
All this creates imbalances. With rates artificially low in China, they produce more goods at lower costs than they should be able to. They sell (dump) them to U.S consumers. The U.S. buys the goods from Chinese businesses in dollars; the Chinese businesses go to their government and exchange the dollars for yuan. The Chinese government then has two choices. It can sell the dollars in the open market, thus putting pressure on the dollar and U.S. interest rates (to rise). Or it can do what it has been doing: it can keep the dollars and buy U.S. bonds with them, thus helping to keep U.S. interest rates low.
The process of selling goods to the U.S. and keeping the dollars in U.S. bonds is analogous to lending money to the U.S. to buy their goods. This creates the trade deficit.
This process also creates inflation in China.
Economists for quite some time have been saying that these imbalances must eventually be corrected; in order to do this China must re-value the yuan against the dollar (raise the valuation versus the dollar), thus raising interest rates in China versus U.S. rates. This would make it more expensive for Chinese businesses and slow the economy down. As Bridgewater points out above, it is in everyone's economic best interest for China to re-value the yuan.
So why don't they? The answer must lie beyond economics. I will end the story here only with a hint (as to what I believe is the case) and let you draw your own conclusions.
Countries may ignore short term economic realities in order to obtain longer term strategic goals. So ask yourself what is China trying to accomplish in the long run that is good for their country? Most likely, what is good for them is not good for us.
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