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When Will China Revalue the Yuan?

By: Gary North, Mises on Money

-- Posted Thursday, 28 October 2004 | Digg This ArticleDigg It!

Currency traders have to live with this question continually. He who is on the wrong side of that trade will get hammered, the way that those who were short the dollar and long the peso got hammered when the Mexican government floated the peso in the summer of 1976. I can remember one hard-money investment advisor who had touted investing in pesos in early 1976, because you could make a safe, guaranteed 200% per annum on your money. I also remember his "Sell!" notice, sent by first class mail, mailed a day after his clients lost up to $35,000 per futures contract. Too late, of course, as he knew when he sent it.

The Chinese central bank’s floating of the yuan – or more likely, controlled ("dirty") floating – will have repercussions on us when we shop at Wal-Mart or other retail outlets that sell Chinese-made products. These products will get more expensive, assuming the yuan moves up, which all commentators assume, including me.

The question is: How soon?


Fixed currency exchange rates are price controls. But, unlike most price controls, fixed rates are controls on products produced by government-licensed monopolies: central banks and commercial banks.

Price controls produce gluts of those products whose prices are set above the free market price, i.e., price floors. Price controls produce shortages of products whose prices are set below the free market price, i.e., price ceilings.

A price control on currencies is simultaneously a price floor (the overpriced currency) and a price ceiling (the underpriced currency).

The Chinese central bank, operating at the discretion of the Chinese government, has established a price ceiling for the yuan and a price floor for the United States dollar: 8.3 to one. This has produced heavy demand for the yuan in terms of the dollar.

To avoid a shortage of yuan – "Sorry, no yuan for sale at the official price" – the Bank of China keeps expanding the monetary base. It creates yuan, and then uses some of the newly created yuan to purchase dollars in the open market, with which it then purchases U.S. Treasury debt.

The alternatives to this policy are these: (1) float the yuan – i.e., abolish the price controls – which will raise its price in terms of dollars; or (2) allocate access to yuan on a basis other than open market purchase. In other words, either "high bid wins" or "stand in line." Currencies are like other scarce commodities. They are allocated either by price or by favoritism, i.e., "Get to the front of the line by doing things my way."

There was a time, prior to August 15, 1971, the day Nixon

  1. unilaterally told the Treasury to stop selling gold,
  2. floated the dollar, and
  3. imposed price ceilings on everything except raw agricultural products, when conservatives argued for fixed exchange rates "to stabilize the currency markets and reduce risk." In other words, they argued for price controls on currencies, even though they also argued for free market pricing on all other items offered for sale. Today, there are few economists outside of China’s central bank who call for fixed exchange rates. They have learned their lesson. The free market works. It lets buyers and sellers set prices, thereby avoiding gluts and shortages.

Fixed exchange rates never did stabilize the currency markets. They stabilized the official price of currencies in relation to each other, but always created gluts and shortages in the currency markets. Then, from time to time, a central bank would devalue its currency in an overnight change of policy, which inflicted huge losses on currency traders on one side of the transaction and huge profits for those on the other side. It was official price stability for a while, and then instability on a massive scale without much warning, other than official assurances that the change was not being contemplated.

I remember Treasury Secretary John Connally’s press conference on Monday, August 16. He was asked by some reporter why he had assured everyone that the government was not contemplating such a policy. He gave an honest answer. If he had told the truth, he said, the run on the dollar by foreign central banks to buy gold from the Treasury at $35/oz would have been even greater.

The Dow rose almost 33 points that day – a huge increase in those days.

The Chamber of Commerce and the National Association of Manufacturers issued positive press releases. No more inflation!

Within a year, shortages were everywhere: the inevitable effect of price and wage controls. There had been a gasoline war going on that weekend in California. I can remember prices at 21 cents a gallon. Normally, prices were around 30 cents. Gas stations ran out of gas and then went out of business. But it was great for 7-11 franchises. That was the era in which gas stations set up convenience stores.

Nixon’s price/wage control program was abandoned in late April, 1974, after it had disrupted American markets. The system had never been enforced vigorously or else the disruptions would have been worse. Nixon resigned in August.

Treasury gold sales were never restored. In January, 1980, gold was selling for over $800/oz – briefly.

The dollar was permanently floated in December, 1973, although the float has been "dirty" for much of the time: some central bank intervention by one or another central bank. Today, only China enforces a fixed rate.


From time to time, I read about "exported deflation" into the United States and "exported inflation" from the United States. A recent example of this line of reasoning appeared in The Asia Times. The author wrote:

Dollar hegemony emerged after 1971 from the peculiar phenomenon of a fiat dollar not backed by gold or any other species of value, continuing to assume the status of the world’s main reserve currency because of the US’s geopolitical supremacy.

This is nonsense. Dollar hegemony emerged after 1945 because the United States was the world’s strongest economy. The Bretton Woods international monetary agreement of 1944 assured dollar hegemony. When Nixon broke the terms of Bretton Woods by closing the gold window, he did not undermine dollar hegemony. There was no other central bank/nation willing to re-establish gold convertibility. So, the dollar has won by default.

Such currency hegemony has become a key dysfunctionality in the international finance architecture driving the unregulated global financial markets in the past two decades.

This is true enough, but without the cooperation of other national governments and central banks, this hegemony could not be maintained. The hegemon is not in a position to force other central banks from re-establishing the gold standard.

This may be overstated. Because most countries store their gold in the vault of the Federal Reserve Bank of New York, there may be some pressure: a threat by Washington to confiscate a nation’s gold. If this threat has been made, it has been made very quietly. If the U.S. ever did this, foreign nations could torpedo the dollar by selling T-bills in one retaliatory move. Tit for tat is a well-respected policy internationally.


Our author continues:

China’s overheated economy is the result of hot money inflow caused by dollar hegemony.

This is nonsense. The Federal Reserve System has no authority in China. The FED has been increasing the U.S. adjusted monetary base at a mid-single-digit rate. The Bank of China has been increasing its money supply at rates much higher. The hot-money inflow of dollars into China has to do exclusively with China’s policy of making available cheap money at a fixed rate. The old economic rule holds up: "At a low price, more is demanded." The Chinese central bank is subsidizing the creation of demand for its own currency by fixing the rate below the market. Then, in order to meet world demand of yuan in dollars, it creates fiat money. To blame the FED is ridiculous. Blame the Bank of China.

By the way, "dollars" do not "flow into" China. They move from some accounts in large multinational banks into other accounts. Jones buys yuan with dollars and transfers this money to Wong, whose account rises. Jones bought yuan from Chen, who may buy T-bills. Or, more likely these days, Jones bought yuan from the Bank of China, which now buys T-bills.

While paper dollars do circulate in third-world nations whose nationals have moved to the U.S. and mail home dollars, the number of paper dollars in China is minimal, as far as anyone knows. If they do circulate, they came from Chinese residents in the U.S. who sent money home to their families. Federal Reserve Notes do not circulate in China’s capital markets.

China’s developing economy should be able to absorb huge amounts of capital inflow, but dollar hegemony limits foreign investment to only the Chinese export sector, where dollar revenue can be earned to repay capital denominated in dollars. Since China’s export sector cannot grow faster than the import demands of other nations, excessive dollar capital inflow overheats the export and exported-related sectors, while other sectors of the Chinese economy suffer acute capital shortage.

This is also nonsense. Dollar hegemony has nothing to do with which sector of the Chinese economy is favored by investors. Investors with dollars in their bank accounts are buying yuan in order to get in on China’s economic boom, which is being sustained by the Chinese central bank’s policy of monetary inflation. China’s economy is a bubble economy. Investors are willing to buy in to any sector where they can find Chinese "cousins" to expedite deals.

Overheated economies produce growth-inhibiting inflation through excessive import of money and sudden rises in prices for imported commodities and energy.

He has it exactly backward. Central bank inflation of a nation's currency is what creates an overheated domestic economy. Central bank inflation can also create a boom in a foreign nation’s economy. How? By lowering foreign interest rates. How? By purchasing that nation’s treasury debt. This is taking place in the United States today. It is the inflow of capital from the Bank of China that is subsidizing the U.S. boom, not the other way around. China is running a $100 billion trade surplus with the United States. It is buying U.S. assets, mainly T-bills, with this excess $100 billion.

It is not the excessive import of foreign capital that causes economic overheating in China. It is the boom created by monetary inflation, coupled with China’s fixed exchange rate policy, that sucks in foreign investment capital. Investors love to invest in bubbles.

The imported inflation is then re-exported, causing inflation in other parts of the global economy.

This man does not understand economic cause and effect. Imported inflation is not re-exported. What is exported are cheap products made in China. While it is wrong to speak of "exported deflation," because deflation is accurately defined as "a decrease in the money supply," it is legitimate to speak of price competition. China is surely price competitive. Capital flowing into China makes Chinese producers even more productive. Prices fall, or else fail to rise as rapidly as they otherwise would have, in nations that import Chinese-made products.

Inflation causes interest rates to rise, which in turn causes unemployment and recession in all economies that are plagued by it.

But China is price competitive. It is pressuring consumer goods prices in foreign nations to fall. This causes interest rates to fall: a lower rate for the price inflation premium that is built into in long-term loans by lenders who demand compensation for the threat of depreciating money.

Add to this factor the demand for U.S. T-bills by the Chinese central bank. It causes American short-term rates to fall. Rising demand for T-bills from China lowers the rate of interest because the Treasury can sell T-bills at a lower price. It is China’s central bank, not the FED, that is the main source on the supply side for today’s low interest rates in the United States.

Dollar hegemony enables the US to be the only exception from macroeconomic penalties of unsynchronized exchange rates and interest rates. The US, because of dollar hegemony, is the only country that can claim that a strong currency that leads to trade deficits is in its national interest in a global economy dominated by international trade. This is because a strong dollar backed by high interest rates helps produce a US capital account surplus to finance its trade deficit.

High interest rates? In the United States? Have you checked your rate of return from your passbook savings account or money market fund? What has this guy been smoking?

Having misunderstood economics, and having perceived low interest rates in the U.S. as high interest rates – i.e., imposing bad economic theory on existing economic facts – the author then does something remarkable. He draws a correct conclusion.

The issue is not whether Asian central banks will continue to have confidence in the dollar, but why Asian central banks should see their mandate as supporting the continuous expansion of the dollar economy at the expense of their own non-dollar economies. Why should Asian economies send real wealth in the form of goods to the US for foreign paper instead of selling their goods in their own economy? Without dollar hegemony, Asian economies can finance their own economic development with sovereign credit in their own currencies and not be addicted to export for fiat dollars. As for Americans, is it a good deal to exchange your job for lower prices at Wal-Mart?

There is one answer to all of these questions: mercantilism.


Asian politicians are the victims of a false economic theory that was refuted by Adam Smith in 1776. They have been hypnotized by the success of the post-war Asian tigers in building their economies through exports to the West, especially the United States. That legendary success was based mainly on the increased productivity of Asian industry through the creation of domestic capitalist markets.

Yet, even here, there was a mercantilist element. Asian exporters were governed by domestic government bureaucracies. Only certain products were allowed to be exported. The most well known of these bureaucracies is Japan’s MITI: the Ministry of International Trade & Industry.

Like mercantilists in the seventeenth century, today’s mercantilists draw a false conclusion. Instead of working to reduce the control of government over the domestic economy, especially central bank control, Asian politicians conclude that government control is the basis of the success of the export sector. Also like seventeenth-century mercantilism, the political benefit from catering to a minority sector of the economy – exports – is high. Exporters know where their bread is buttered: in Parliament. They and the politicians can justify Parliament’s splendid pay-off – pressuring the central bank to lower the international value of the currency by inflating it – by arguing that "exports are good for the economy."

The hegemony of the dollar is indeed one factor in the Asian governments’ willingness to subsidize exports to the U.S. OPEC governments that control the export of oil – socialist ownership – demand payments in dollars. This is an American payoff to Middle Eastern sheiks for promised support against domestic revolution: American-made weapons and training. This is the hegemon in action.

Nevertheless, the main reason for Asian governments’ policy of subsidizing American consumers through currency depreciation is domestic mercantilism. There is a sweetheart deal among Asian exporters, politicians, bureaucrats, and central bankers. We Americans are the beneficiaries at the expense of Asian consumers.

Grab it while you can. The gravy train won’t last forever.


There is no question that the Chinese economy is overheated.

This is the exclusive fault of the Bank of China.

The central bank’s policy of monetary inflation has created the boom phase of what Austrian School economists describe as the boom-bust cycle. Austrian economists blame central bank inflation for booms and busts. In this sense, Austrian economists are unique. Their view is not popular.

China has a tiger by the tail, to quote the title of a 1972 collection of articles written by Austrian economist F. A. Hayek. China’s central bank has created the boom phase of the economy. If it does not cease inflating, there will be a crack-up boom, as Ludwig von Mises called it: the destruction of China’s currency in mass inflation. On the other hand, if the bank slows the rate of monetary inflation, there will be a recession or worse. The bubble will pop.

Bad macro!

Economic causes and effects are not racial. They are not national. They operate in China, just as they operate everywhere else. The Bank of China has created a boom that is as artificial as the yuan’s fixed exchange rate with the dollar. This boom cannot be sustained without negative consequences. It also cannot be ended without negative consequences.

Politics dominates China. The Communist Party of China is no longer Marxist in economic theory, but it surely is Leninist in political power. These aging leaders are not going to risk losing their power by calling a halt to the boom – not unless domestic inflation escalates. The pain of such economic pressures on politicians will determine the timing of any change in Chinese monetary policy.

Consider the political pressure of unemployed workers in huge cities where jobs have disappeared. This pressure is very different from, and more excruciating than, recessionary pressures on self-sufficient family farms in distant rural regions. We are watching 200 million people streaming into Chinese cities in one decade. There has never been a population move like this one. These uprooted newcomers are now concentrated in tight geographical areas. Take away their jobs and their dreams overnight, and you have a truly revolutionary situation on your hands. What’s a little price inflation compared to this? What’s a whole lot of price inflation compared to this?

Terry Easton thinks that the Chinese government will keep fixed exchange rates until after the 2008 Olympics, which will be held in Beijing. That’s as good a political guess as any. Of course, serious economic pressures can surface before then.

Saving face is higher on most Asians’ value scales than saving money. Capitalism is a new import there. The fear of shame is deep-rooted. Chinese society is a shame society. This will add political pressure to maintain the fixed rate. China wants lots of visitors, and keeping the yuan low will encourage these visitors to come. Urban discontent in the streets is not favorable to foreign tourism.

But there are other considerations. China is now running a small trade deficit with most of the world, even including the $100 billion trade surplus with the United States. Capital is flowing into China, and not just dollar-denominated capital. If domestic prices start rising rapidly, exports will be reduced. There will be pressure on the Bank of China to slow the rate of monetary inflation. If the central bankers have not read Austrian School economics – this seems likely – they may not understand the size of the tiger they have by the tail or how fast he can turn. The bankers may risk a slowdown, not expecting a depression.


The political prestige of the Olympic games is high. China’s rulers want to share in the glory of the games, which will mark China’s entry into the world’s ruling nations. But four years of price inflation can add up. So can shortages of price-controlled items, such as water and electricity, which are already being rationed politically.

Political power is not democratic in China. The power elite in China is in a strong position to pursue bad monetary policy. I do not think most Westerners understand China’s political rulers and the pressures they feel.

I think Chinese politicians understand power better than American politicians do. Power has been a life-and-death matter in Communist nations. These men grew up during Mao’s cultural revolution. They survived.

An American retreat from Iraq will motivate China’s rulers to abandon the dollar if they think there will be a switch to the euro or other currencies by OPEC. It is not losing face to abandon a sinking ship.

Let us not be naïve. China’s politicians set central bank policy. The political dog wags the central bank tail in China, unlike in the United States.

I expect an end to fixed rates in China within a year after the United States pulls out of Iraq. If U.S. troops are still there in 2008, then I would expect floating rates before 2009. But I don’t think we will have to wait that long.

Gary North [send him mail] is the author of Mises on Money. Visit

-- Posted Thursday, 28 October 2004 | Digg This Article

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