Wednesday, March 26, 2008

Hot money inflates China's currencey reserves

Problems are brewing in the Far East with hot implications for the rest of the World. Michael Pettis, professor at Peking University's Guanghua School of Management, writes in his blog that Chinese foreign exchange reserves rose by a surprising $57.3 billion over the month of February. In his opinion $30 billion of that increase comes from hot money inflows that are accelerating in recent months due to RMB appreciation. Pettis argues in favor of a maxi-revaluation of the currency.

Since at least 2002-2003 China has been caught in a monetary trap. By tying the value of the RMB to the dollar, and especially by setting it too low, the Chinese authorities ran the risk that in a time of excess global liquidity they would find themselves in the position of excess money inflows leading to excess domestic money expansion, which would be reinforced as domestic money expansion funded rising industrial production, which would cause an increase in the trade surplus and so increase money flows further.

Because of the self-reinforcing nature of this system, this process must necessarily go on until a very sharp adjustment stops it. The adjustment could come in the form, as it has in the past to China and other countries, of sharply rising domestic investment (“good” version: massive infrastructure spending; “bad” version: forced corporate investment via rising inventories), rapid debt deflation, a collapse of the banking system into bad debts, a breakdown of sovereign external or domestic credit (from excess fiscal expansion), or out-of-control inflation (which is, of course, one way that the currency can adjust), or it could come as a combination of these factors. It is possible but unlikely that the adjustment will be benign, and the longer we wait the less likely it is. This last statement is hard to prove but seems reasonable largely because of historical precedents......The only useful way to address capital inflows is to adjust the currency....The main argument in favor of a maxi-revaluation, however, is not that it will be painless. The main argument is that the alternatives are much more painful.

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