More on the Global Currency War

Unfortunately, with Europe joining the US in calling for China to relax its pegging policy there appears to be the beginning of a trade war developing. The following quote from Premier Wen JiaBao is important for many reasons:

“'Europe shouldn’t join the choir' clamoring for a higher yuan, Wen told a business conference yesterday before an EU- China summit in Brussels. 'If the yuan isn’t stable, it will bring disaster to China and the world. If we increase the yuan by 20-40 percent as some people are calling for, many of our factories will shut down and society will be in turmoil.'”

Wu, Zijing, Neuger, James G., 2010. China hardens opposition over yuan gains, tells eu to back off. Bloomberg News, Oct. 6.

I have every reason to believe that Wen has made a correct assessment regarding the chances of a financial disaster in China and the world if the pegging policy is removed for the Yuan.

However, from the beginning all knew the Chinese pegging policy was not sustainable. It produced a situation inside China where costs were artificially low. Further, profit margins at Chinese firms are razor thin and based on the artificially low value of the Yuan. Any change in Yuan valuation will certainly put many firms out of business.

The forces of supply and demand for free currency markets work very well in allocating resources for the global economy. As trade balances (and the demand profile for currency) change the adjustment takes place over months or years often at a natural, gradual pace if a financial crisis does not exist and if the funding structure of a sovereign country is reasonable.

China has decided as a matter of policy to attempt to contradict the naturally occurring forces of currency markets in an effort to create social and economic stability and growth. Unfortunately, history has shown that this approach does not work for the medium or long-term. Financial pressures build up and must be released. This is the process that the global economy is currently experiencing.

I hope rationality prevails! China, the EU, Japan and the US have too much to lose if an all out trade war over currency valuation erupts.