Friday, February 4, 2011

Quantitative Easing as a weapon in the Global Currency War

China and the US are in an escalating currency war.  China has been keeping their Chinese Yuan currency artificially low and hoarding trillions of US dollars to keep its value high. The US Federal Reserve is responding with “Quantitative Easing”,  a big name for creating money from nothing.  Since last November, the Federal Reserve has been “printing” (making it electronically) about $70 billion US dollars a month to buy back US bonds.

China has kept its currency undervalued for years to maintain their cheap labor costs, though every year their leaders promise to let it float. And rather than keeping their foreign reserves in a basket of currencies, it has recently been revealed that China has been holding on to almost 3 Trillion US dollars, keeping it out of circulation and driving up the dollar value. This revelation surprised many who thought that China had spread their foreign reserves equally among dollars, Euros and Yen.  It also explains one of the reasons China has been so obstinate about raising the value of their Yuan currency against the dollar since that would devalue their Trillion dollar holdings. The 40 to 60% Yuan currency increase being called for by the US and Europe would erase up to $1.5 Trillion of China’s foreign reserves overnight.

The idea behind quantitative easing is that it increases the money supply and stimulates the economy. The Japanese Central Bank tried it in 2000 in an attempt to stop their rising deflation. It didn’t stimulate Japan’s economy or end their deflation, but it lowered the value of their Yen currency for a while.

China is furious about the Fed’s quantitative easing and says the US has no right to “devalue”  the dollar.  They claim that the US dollar is a global currency for holding foreign reserves and not owned nor should it be managed by the US Federal reserve. Some fiscally conservative Americans object to the Fed’s actions because they think it will result in rampant inflation in the US.  But we continue to believe that the amount of currency lost to the US economy in the past couple of years, due to the collapse of housing and loss of jobs, dwarfs the amount the Fed is putting back into the economy each month.

The bigger risk is that China might quickly dump all their US dollars on the market while the dollar is still high. If this was done in the period of a month or two, it could flood global currency markets with dollars. The result would be a massive devaluation of US currency over night.  Though this might look like hyperinflation, it would likely be something we have never seen before. There is no evidence that China is converting their dollars to other currencies at this time, but what they are doing is buying businesses and properties across the US while prices are low and their dollars have value. We are watching the daily fluctuations in foreign currency and thinking about what the first signs of China making a move to sell their cache of dollars might be. And we are wondering what unique investment opportunities a massive exchange of dollars into other currencies or assets might create.


Steve said...

This should raise the larger question of why anyone is ALLOWED to manipulate the value of the money that millions sacrifice much of their life to earn. The book "whatever happened to penny candy" although written for kids is great for adults too. Also "Lessons for the Young Economist" a free pdf on is written for high school but great for kids. Much of is great for truly understanding this issue and pulling back the curtain on Ben Bernanke.

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