Yuan Revaluation?

I am worried about the US dollar. People far smarter than I are worried about the US dollar.

There is some speculation that the dollar will rapidly crash through the $1.35 mark against the Euro. Right now the US dollar is floating at $1.28 per Euro. The $1.35 mark is just another 5% away which is not far as the dollar has already declined from its high of costing only .84 cents to buy a Euro to today’s values.

The dollar has not slid against the Yen and the Yuan as much for two reasons. First, it has seemed that the Asian central banks are treating the US dollar as a perfectly elastic good right now. They are willing to be the buyers of last resort of US dollars at almost any price in order to artificailly suppress the value of their home currencies in order to facilate export led growth. Secondly, the Chinees have been willing to defend the value of the yuan aggressively as they maintain a fixed peg against the dollar. Actually these are the same reasons.

This good news may come to an end soon. Stirling Newberry’s Dkos diary links to a NY-Times article which indicates that the central bank of China is using its foreign currency reserves to began bailing out China’s banks. The first bail-out package is consuming $45 billion dollars of hard currency which according to international economist is just a good start. The two banks in question are only having half of their bad loans liquidated and the banks have less than half of the market. Using simple logic we have a ground floor number of at least four times the current intervention as the amount that China would need to spend today to straighten out its banking sector.

The most interesting thing in this article is that the Chinese central bank are willing to allow the bailed-out banks to convert their dollars into yuan at 8 yuan/dollar instead of the current peg of 8.28/$. This is a minor revaluation of the yuan and weakening of the dollar, only 3.3% more purchasing power will flow to each yuan but the importance is not the magnitude of the change but the fact that there is a change in Chinese policy.

IF this Chinese policy change continues and it prompts the Japanese central bank to follow, then we will see a rout of the US dollar on the international market as we will see a rational currency weakening cascade. That will lead to high US interest rates, and the cut-off of international capital flows which have been keeping us afloat for the past decade.

It will not be pretty.

Crossposted at Fester’s Place