Deflation in USA and Appreciation of

Chinese Yuan
Background
The US policymakers are showing concerns on lack of aggregate demand, and hence, high
unemployment and very low inflation.

At the same time, some US lawmakers are not happy with the pace of appreciation of the Chinese
currency. They propose trade sanctions or tough negations with China.

In our view, both the issues of risk of imminent deflation and getting China to act, can be solved by the
US Fed, in one stroke of pen.

Quick Analysis of Fed Actions in Last 24 months

The US Fed, in response to the near collapse of world financial system post Lehman bankruptcy took the
US rates very close to zero and started buying US Treasuries and Mortgage Bonds. However, at the same
time, it started paying interest on the balances held by commercial banks with Fed. Many people
consider it cardinal sin of Central Banking to pay interest to Commercial Bank balances with the Central
Bank. We believe Fed decided to commit the cardinal sin because it was not sure of how much long-
lasting damage has been done to real sector, and wanted to avoid fears of hyperinflation.

The payment of interest has worked and most of the money pumped by Fed has come back to it by way
of reserve balances.

1400000

1200000

1000000

800000

600000

400000

200000

0
7 7 7 7 7 7 8 8 8 8 8 8 9 9 9 9 9 9 0 0 0
n-0 r-0 y-0 l-0 p-0 v-0 n-0 r-0 y-0 l-0 p-0 v-0 n-0 r-0 y-0 l-0 p-0 v-0 n-1 r-1 y-1
Ja Ma Ma Ju Se No Ja Ma Ma Ju Se No Ja Ma Ma Ju Se No Ja Ma Ma
Now, nearly 24 months after the collapse of Lehman, it is clear that the USA is at the brink of deflation
and sustained low growth.

Analysis of China’s Currency Management

Many believe that the exchange rate of Chinese currency is decided in Beijing by PBOC. While,
theoretically, this is true, the actual operation of exchange rate happens in the money and bond markets
in the USA.

The Fed has ability, and now scope, to alter the nature of US Bond Markets to force PBOC to act in the
manner which US thinks is in the best short-term interest of the USA.

What Can Fed Do?

The Fed can make two simultaneous announcements. First, that Fed will charge a safe keeping charge of
1% per annum on all excess balances held by commercial banks with the Fed. Second, the Fed can force
the commercial banks to hold treasury securities to the extent of say, US$1.5 trillion, over say, next one
year.

The combined effect of these two announcements will be that the yield of most short-duration
treasuries will go below zero immediately. This will make holding of treasuries extremely unattractive to
China and also will totally dry up the supply of US Treasuries for next one-year or so.

With no avenue to deploy the excess dollars generated by its currency operations, China will be forced
to revalue its currency to a level that will balance inflow and outflow.

With treasuries becoming unattractive, the banks and other lenders will be forced to increase lending to
commercial sector, aiding recovery to some extent, and removing fears of deflation to large extent.