Tuesday, October 16, 2007

China - Sticking to the Game Plan

China still appears to be sticking with their game plan regarding the pegging of the Yuan to the Dollar in a tight fixed range, despite inflationary and other pressures on their economy. From a distant perspective, the Chinese government is being very wise in their policy which is built around:

  • Diversifying over time from the Dollar to other currencies to reflect the overall allocation of trade with their nation. More reserves will be held in Euros, Pounds, etc. This reduces currency fluctuation risk.
  • Purchasing other assets beside U.S. government bonds. The recent purchases have included private equity funds, stocks, bonds of other nations, and real estate. These moves increase the return on the reserves while diversifying the risk from a single type of instrument (U.S. treasuries and bonds).
  • Maintaining the peg of the Yuan to the Dollar in a tight range. This eliminates the risk of major moves in the currency market from impacting the Chinese economy. This implies that the government will not have external Forex traders and hedge funds dictate their future. Strict control is maintained over the peg preventing foreign currency market arbitrage plays that would cause a run on the Yuan with associated economic devastation.
  • Cleaning up the banks in China. Many banks have bad debt with poor controls and the government has taken steps to clean up the mess including foreign ownership of some banking assets to reduce risk. One primary reason for the currency peg was to protect the banks that were on shaky structural ground. This provided the government with time to clean up the mess and align the banks with western financial standards.

The downside of the government policy in regards to the peg is the friction with trade partners and inflationary pressure associated with runaway growth. During the past year interest rates were raised several times in an attempt the cool the economy, and other measures were implemented to reduce lending. However at this point the overall game plan has worked out well for China over the past few years. The question will be can they stick to the plan in the upcoming months.

Yuan, Rupee Rise at Record Pace in Fight on Inflation