In the Red

With a rising and uncontrollable current account deficit, now standing at 7% of the GDP, the U.S Government and the Treasury are now looking to put the blame on China.

China, who pegged the currency, Yuan, against the dollar until last year seems to be the key driving factor for this large current account deficit. With continuous pressure from other developed countries, China last year made the currency partially floating. The subsequent appreciation of the Yuan made the commodity market crash as the demand from China began to decrease.

Cautious incrimination

An appreciation of Yuan would make Chinese products more expensive and lead to a decrease in the demand for Chinese products. This is significant for the US who is the single largest recipient of Chinese import.

With Secretary of Treasury John Snow heaping pressure on the Chinese, insinuating it to be a rate-mainpulator, analysts forecast a 30-40% appreciation in the Yuan over time.

But U.S Treasury will be cautious in calling China a currency manipulator. Chinese appreciation of its currency will lead to a reduction in it’s financing of the US twin deficits (current account deficit and trade deficit). This would lead to a sharp fall in U.S. dollar, increase in interest rate and a hard landing for U.S.

Playing the cost card

The key reason why China has kept its currency low is to make its exports cheaper and attractive. China can afford to keep its currency low because of the cheap domestic labour market, compared to its EU & Asian counterparts.

But the question is whether the appreciation, which increasingly seems inevitable, will be a short term or a long term appreciation. As the currency market are short sighted, a sudden appreciation of the Yuan will leading to massive unwinding of positions. This in turn will lead to a crash in the major markets and slowing down of the world economy.

Alternatively the Yuan appreciation should be a slow and stable process. A 15% appreciation in Yuan over two or three years can be absorbed by the financial markets with minimal disruption.

The world watches the red beast nervously.

(Swaroop George is a Process Consultant and an Investment Advisor. He is a disciplined contration investor in the financial markets. He covers his thoughts on investments through his blogs.)

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