How it works: The Dollar-Yuan peg

Struggling to get your head around the People’s Bank of China’s policy of pegging the value of their currency, the renminbi, against the US dollar? Take ten minutes to review the following video clip and text that follows.

Ignore the first couple of seconds of the clip before Peter Schiff explains the path of least resistance for the yuan (renminbi) and the process which keeps the peg in place.

Jim Grant of Grant’s Interest Rate Observer explains the process as follows (“Bullish on turmoil” pg 29-32; recommended reading):

As you know, China sends merchandise east; America sends dollar bills west. The dollars are presented for purchase to the People’s Bank of China, which buys them with renminbi it prints up for the very purpose. Some of these renminbi it erases, or “sterilizes,” as a counter-inflationary measure, but most go to work in the Chinese economy, lifting share prices and mobilizing real estate developers.

Having “monetized” those dollars— i.e., turned them into renminbi—the PBOC or its agent invests them in U.S. government Treasurys or agency securities. A very different business is this from the arrangements formerly prevailing. Way back when, the United States would discharge its debts to China not in paper or electronic impulses, but in gold. Ships on the backhaul from Long Beach to Shanghai would be carrying gold bricks, literally the building blocks of the U.S. monetary base. Here was de-leveraging you could see. Debtor nations lost money; creditor nations gained it. Debtor nations deflated; creditor nations inflated. Such reciprocal monetary adjustments kept the nations in approximate balance. At least, under the classical gold standard, the world’s reserve assets didn’t keep rolling in one direction as they do today, that direction being west, across the Pacific.

Governments prefer today’s arrangements, of course. In China, factory chimneys smoke and markets rally as newly printed renminbi course through Chinese banking channels. As for the great debtor, America, its loss is (or seems to be) purely hypothetical. The dollars it sends to its offshore creditors come bounding right back home again in the form of investments in U.S. debt obligations. The rising pile of America’s external debt is dischargeable in dollars, but what of it? You can create dollars— if you have the right log-in name and password—on a PC. So creditor nations collect dollars, and debtor nations accumulate debts. A harmless enough exercise in money manipulation, you may suppose.

Note that for every dollar that flows to China from the US in payment for Chinese goods, renminbi are created which circulate in China. The dollars don’t stay in the Chinese economy, they’re sent back to the US (and invested mainly in Treasuries). The PBOC can send these dollars wherever it chooses and this won’t necessarily lead to an appreciation in the renminbi and depreciation of the dollar. The appreciation of the renminbi will only happen once money supply growth in China is slowed relative to US dollar supply growth - this is the tightening Schiff refers to. 

The whole point of Chinese policy makers sending dollars to the US is they finance US deficits (borrowing) which means the US consumer and government can continue merrilly on their consumption binge of mainly Chinese goods. The Chinese have implemented this policy very shrewdly over the past two decades to hollow out the US manufacturing base to their own advantage. We expect they will cut the link at a time when it best suits their geopolitical and economic interests. That will be nightmarish for the US dollar.