Ian McMurtrie - Will Inflation Force the Chinese Government to Abandon the Dollar Peg and Sink the United States?

Will Inflation Force the Chinese Government toAbandon the Dollar Peg and Sink the United States?

An Examination of Hyperinflation inChina from an ‘Unholy Trinity’ Perspective

Ian McMurtrieMarch 21, 2009

“Deflation has spread across all sectors;

strengthening the dollar

... Deflation iseverywhere.”

– Mike Whitney

“I view hyperinflation in China as absolutely guaranteed. Zero doubt… this willbe the event that finally ends the US's borrowing binge and

destroys ourcurrency

… Those expecting deflation are in for a surprise.”

– Eric deCarbonnel

Introduction

Presently there is much confusion about the consequences of the quicklyunwinding global economic circumstance – to such a degree that breathless estimates ofthe exact opposite outcomes are rapidly being pronounced (see above quotations). Whatis needed is a means of identifying which, if either, of these predictions is likely. Aperilous economic environment demands careful decision making which requiresaccurate knowledge. However, there cannot be a claim to knowledge when, providedroughly equal data, a profusion of contradictory conclusions are pronounced. Is there amethod or model to resolve these contradictory claims and point ahead to a reasonablecourse of action? Using the theoretical model of the ‘unholy trinity’ of internationalmonetary policy, this paper will examine the large current account surplus in China, thesignificant deficits in the United States, and the possibility of Chinese hyperinflationdestroying the value of the US dollar.2

Because of the large US current account and fiscal deficits

1

, financed primarily byforeign central bank purchases of treasuries

2

,most “commentators agree…[that] at somepoint the US dollar will have to depreciate by [a] significant amount to reduce theexternal balance and stabilize the US external debt to GDP ratio. The main debate is onwhether this process is going to be

gradual and orderly or sudden and disorderly

.”

3

Theprimary central bank responsible for funding these deficits is the People’s Bank of China(PBoC). The PBoC holds approximately $700 billion in US treasuries, and due to massiveexport-related trade surpluses, runs a current account surplus that requires large scale‘sterilization’ of its enormous foreign exchange income. If the value of the US dollar wereto fall significantly, it would erase significant portions of the accumulated dollar-denominated reserves in China and have a massive effect on the value of its treasuryholdings.

4

Given that the tenuous cycle of US debt and Chinese export is faltering,despite China’s best efforts to contain it, will inflation on the mainland force China todrop the dollar peg and inflate its currency? This is the scenario described by Eric

1

“A crucial feature of the global economy right now is the large US current account deficit and the surplusesof most – but not all – of the rest of the world. The US current account deficit rose from $640b in 2004 to $755bin 2005, to $811b in 2006 (or 6.1% GDP) and is likely to be even larger in 2007. The US, the world’s largesteconomy – and the world’s preeminent military and geo-strategic power – is also the world’s largest debtor…The US absorbs about 70% of the savings that the rest of the world does not invest at home.” NourielRoubini, “The Instability of the Bretton Woods 2 Regime,” July 2007, p. 2.

2

“In 2003, the world’s central banks added $440 billion of dollar reserves…Central banks therefore financed90% of the United States’ $530 billion current account deficit.” Nouriel Roubini and Brad Setser, “Will theBretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005-2006,” February 2005, p. 2.

3

Roubini, Instability, p. 45. My emphasis.

4

“And the eventual fiscal cost of accumulating dollar reserves when the long term nominal and real exchangerate will appreciate are massive. In the case of China such capital losses would be now equal to $200 billion(about 10% of GDP) if the RMB were to appreciate 20% and could rise to as high as $600 billion in three years:the more China prevents its RMB appreciation the larger will be the stock of reserves (over $2 trillion by 2009given current rates of accumulation) and the larger the necessary and eventually unavoidable nominal andreal appreciation (as high as 30% in a matter of three years).” Nouriel Roubini, “Asia is Learning the WrongLessons from Its 1997-98 Financial Crisis: The Rising Risks of a New and Different Type of Financial Crisis inAsia,” May 2007, p. 13.

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