Today, I want to talk about the convertibility of the Chinese Yuan. Because China has announced a five year convertibility plan – which is HUGE NEWS. It’s like the dismantling of a dam wall that’s been holding back a fifth of the world’s water supply. There will be flooding. There will be displacement. The geography will cataclysmically change.

The trouble is that the convertibility of the Yuan has been something of a theme in my past posting. So when I woke up this morning, I thought that I would have to write about something else, and that this was going to be a post about online shopping and the new sales tax bill in the US*. But then I went back and re-read my last big piece on Yuan Convertibility (Observation Number 10: Yuan Convertibility won’t be good for America) – and I realised that post was a bit heavy on the technical/assumed-financial-knowledge. So I’m hoping to rectify that a bit today.

A Background to Exchange Rate Regimes

Most people talk about two main types:

• Fixed Exchange Rate Regimes – where the government/Reserve Bank sets the exchange rate, and controls the exchange of currency.
• Floating Exchange Rate Regimes – where government has no role at all.

You obviously get in-between mixes. And also countries that peg their currency to another (like Argentina has pegged the peso to the dollar – so the peso will move in exactly the same way as the dollar in relation to every other currency, but it won’t move in relation to the dollar).

Now most of us are used to a floating exchange rate. We’ll watch the business news guests lament the weakening/strengthening of the dollar/rand/euro**. And the government sits back and wrings hands and blames IMF conditions of aid.

In China – that’s not what happens. The Chinese have set a trading band (eg. the yuan can trade for between 6 and 7 yuan to the dollar):

If the band looks like it might be breached, the Chinese Central Bank steps in and does one of the following:

1. It sells some of its foreign currency reserves (if the yuan is weakening due to too much demand for dollars);
2. It buys more foreign currency and adds it to its foreign currency reserves (if the yuan is strengthening owing to too little demand for dollars); or
3. It says that the exchange quotas have been met, and prohibits any further foreign exchange.

PS: the thing to remember about foreign exchange (which is always difficult to wrap one’s head around) is that any person in the transaction is both customer and supplier at the same time. If I am buying dollars, I must also be selling yuan. And if I am buying yuan, I am also selling dollars. Trades are therefore between two buyers, or between two sellers.

Basically, the Chinese Central Bank acts as the counterpoint to the market. If there are equal buyers and sellers in the market, then the bank sits back. If there are more buyers of dollars than there are sellers of dollars, then the Bank steps in to make up the difference (by selling dollars, which is the same as buying yuan). And the same applies if there are more buyers of yuan than there are sellers of yuan.

So What Does Greater Convertibility Mean

Well, it means that the government steps back and allows the market to determine the exchange rate. And that’s not necessarily a good thing, because while it opens up China to foreign trade and foreign investment in ways that were just not possible under the existing regime; it also opens up the yuan to speculation and “hot money” flows in ways that were also not possible before…

Scenario:

• The Yuan becomes freely tradeable.
• All the US dollar speculators look at China and see structural reform, strong forex and gold reserves, a liberalising government, and the largest untapped market in the world – equal to a fifth of the world’s population.
• Said speculators then look back at the US, and see a bipartisan government, recession, giant fiscal deficits and magnificently over-the-top social welfare spend.
• Some of them start to move to the yuan.
• The yuan strengthens (there are more buyers of yuan than buyers of dollars!), allowing China cheaper imports.
• And because the People’s Party is focused on internal demand, this results in lively domestic growth***.
• The US, heavily reliant on goods imported from China, is finding them increasingly expensive. And their adjustment process back to internal manufacture is slow and painful.
• US growth declines.
• Seeing this disparity, more investors move to the yuan.
• US growth declines even more.
• The yuan takes on status as a global currency of reserve.
• US dollars then begin returning to US territories where they can be used. And everyone suddenly starts to realise just how many US dollars there are in circulation.
• Lots of money + same amount of goods or fewer = inflation.
• Does it sound like the US could go through its third hyperinflation?
• Why yes. Yes it does.

You have to wonder whether China didn’t just, like, plan it.

*Governments, like all the aged, sometimes get behind the times. Online retailers have been exempt from sales tax, provided that they don’t have a “physical establishment” in the state where the sale was made – as a result of a Supreme Court decision made in the 90s. And in the tradition of all governments/revenue-authorities – when you don’t like a court ruling, change the law. The physical shops are hoping to be delighted – as they’ve been more expensive due to having-to-charge-sales-tax. The bill has been passed by the Senate – and is now waiting to be heard in the House.

**Someone is always lamenting. And calling on government to intervene.

***Previously, China would have been concerned about a strong yuan making their exports less competitive. But they have learned their lesson from the global slowdown. Being reliant on the US and the Eurozone to keep you in production is bad for business. And not sustainable.