Currency Wars_ The Making of the Next Global Crisis - James Rickards [72]
In a globalized world, however, exchange rates act like a water-slide to move the effect of interest rates around quickly. Quantitative easing could be used by the Fed not just to ease financial conditions in the United States but also in China. It was the perfect currency war weapon and the Fed knew it. Quantitative easing worked because of the yuan-dollar peg maintained by the People’s Bank of China. As the Fed printed more money in its QE programs, much of that money found its way to China in the form of trade surpluses or hot money inflows looking for higher profits than were available in the United States. Once the dollars got to China, they were soaked up by the central bank in exchange for newly printed yuan. The more money the Fed printed, the more money China had to print to maintain the peg. China’s policy of pegging the yuan to the dollar was based on the mistaken belief and misplaced hope that the Fed would not abuse its money printing privileges. Now the Fed was printing with a vengeance.
There was one important difference between the United States and China. The United States was a slack economy with little chance of inflation in the short run. China was a booming economy and had bounced back nicely from the Panic of 2008. There was less excess capacity in China to absorb the new money without causing inflation. The money printing in China quickly led to higher prices there. China was now importing inflation from the United States through the exchange rate peg after previously having exported its deflation to the United States the same way.
While yuan revaluation was going slowly in late 2010 and early 2011, inflation in China took off and quickly passed 5 percent on an annualized basis. By refusing to revalue, China was getting inflation instead. The United States was happy either way, because revaluation and inflation both increased the costs of Chinese exports and made the United States more competitive. From June 2010 through January 2011, yuan revaluation had moved at about a 4 percent annualized rate and Chinese inflation was moving at a 5 percent annualized rate so the total increase in the Chinese cost structure by adding revaluation and inflation was 9 percent. Projected over several years, this meant that the dollar would decline over 20 percent relative to the yuan in terms of export prices. This was exactly what Senator Chuck Schumer and other critics in the United States had been calling for. China now had no good options. If it maintained the currency peg, the Fed would keep printing and inflation in China would get out of control. If China revalued, it might keep a lid on inflation, but its cost structure would go up when measured in other currencies. The Fed and the United States would win either way.
While revaluation and inflation might be economic equivalents when it came to increasing costs, there was one important difference. Revaluation could be controlled to some extent since the Chinese could direct the timing of each change in the pegged rate even if the Fed was forcing the overall direction. Inflation, on the other hand, was essentially uncontrolled. It could emerge in one sector such as food or fuel and quickly spread through supply chains in unpredictable ways. Inflation could have huge behavioral impacts and start to feed on itself in a self-fulfilling cycle as merchants and wholesalers raised prices in anticipation of price increases by others.
Inflation was one of the catalysts of the June 1989 Tiananmen Square protests, which ended in massacre. Conservative Chinese counted on a steady relationship between their currency and the dollar and a steady value for their massive holdings of U.S. Treasury debt, exactly as Europe had enjoyed in the early days of Bretton Woods. Now they were betrayed—the Fed