“Chairman of the U.S. Federal Reserve Ben Bernanke recently opposed Congress from passing any legislation to pressure the Chinese yuan. Bernanke and his associates repeatedly testified to Congress that China will eventually adjust its currency; any sanctions will not help with the adjustments.” This was a statement made by a Western researcher in a financial summit I recently attended. At the same time, a few other foreign researchers criticized Bernanke for defending the Chinese currency policy. They believed that U.S. monetary policy makers are cooperative in their stance to create an environment where the Chinese yuan will slowly appreciate. By following their logic, it is possible to derive such forecasts: The rise in the U.S. interest rate will reduce the pressure on the appreciation of the Chinese yuan. This allows the flow of foreign capital to reverse back to the U.S. for a capital gain. However, I cannot completely agree with this analysis. Let me further elaborate.
The logic behind their analysis is that as long as the U.S. raises interest rates, the attractiveness of holding onto U.S. dollars increases. Because Chinese interest rates are much lower than those of the U.S., foreign capital that was invested in the Chinese yuan will slowly move out of China to the more attractive U.S. dollar. I won’t comment on the correctness of this analysis now; let me begin with an example of the Southeast Asia financial crises.
In the Asian financial crisis, George Soros was profiting by investing in U.S. dollars. His financing came from the currency of Southeast Asian countries. As long as Southeast Asian currencies depreciates and the U.S. currency appreciates in relative terms, Soros can profit from such a difference. The central banks of Southeast Asia responded to Soros’ action by raising loan interests, a policy they believe will increase the financing cost for Soros and therefore abort his opportunistic behaviors. However, after the announcement of such policies, the depreciation of the Southeast Asian currencies accelerated, and the situation exacerbated. The manipulations of the loan interest by Southeast Asia’s central banks, according to the MM theorem, are monetary-contraction policies. In other words, it hurts the economies of countries enforcing such a policy and in the long run, hurts the value of their currency. Because Soros is already bullish on the U.S. currency and it is inevitable that the U.S. dollar will appreciate relative to Southeast Asian currencies, any adjustments to loan interests will not reverse the current trend. By implementing such policies, central banks will cause a damaging effect to the economy.
Careful readers may have already guessed where I am leading. By replacing the main character with the Chinese yuan and the supporting character with the U.S. dollar, this is just an upgraded version of the Asian financial crisis. We can imagine that the U.S. dollar is the Thai baht in 1997 and the Chinese yuan is the U.S. dollar in 1997. We can find a surprising correlation with historical terms. Economists believe that by raising interest rates, the U.S. can increase the financing cost for capital flowing out of the country and increase the attractiveness of retaining capital in the U.S., but this is a total misunderstanding of how finance actually works. The rise in interest rates is a contractionary monetary policy that will lower consumer and investment confidence. Capital investment in the U.S. will look more unattractive, and stock prices will fall. In the long term, it will depreciate the U.S. dollar and increase the pressure of appreciating the Chinese yuan.
Will the increase in U.S. interest rates help reform the Chinese yuan? The Southeast Asian financial crisis tells us otherwise. What do you think?