The Economy Guy

Issue: 11/16/07 Friday

Nothing special happened today in all the markets – so I will take this opportunity to talk about something much more important – Inflation in China.  Here is a case study of what happens to a country that has a managed, controlled economy.  The solutions are very logical, and applicable to any country.

Inflation is going up in China right now, and it’s causing “dislocations” in its economy.  Dislocations is a fancy word for trouble.  The current inflation rate is between 6 and 7%.  China’s response to this inflation is to increase interest rates.  That is the classic method of fighting inflation.  So far so good.  By “dislocations” I mean that the country folk want to make as much money as their city cousins.  That is a BIG problem for the Chinese, as one of the biggest fears in China is that “change” is brought about by Revolution.  Thanks Mao.

However, China has another problem.  It manages its exchange rate to the dollar.  The US is it major trading partner (if you consider one way trading to be a partnership).  So, it fixes its exchange rate, rather than let the market decide what it should be.  The Chinese Yuan is artificially cheap in the world’s market, and that’s why you find so many Chinese products in all our stores across the US, and throughout the world.  Europe is in the same pickle as the US today.  That means that we are purchasing Chinese products, and that means the Chinese are awash in Yuan, and that’s causing the inflation.

Remember, the primary cause of inflation is additional money.

So, what can the Chinese do to fight their inflation in addition to higher interest rates?  That’s easy.  They must change the exchange rate.  The “experts” are predicting that China will raise its exchange rate against the dollar by more than 25% over the next year.  That means all those Chinese products will cost at least 25% more next year, here in the US.  (Did you get the hint here???)

The Chinese then have another problem of their own making.  They have purchased a huge amount of US Bonds with all those excess dollars that are entering their economy.  When they increase their Yuan exchange rate, they are decreasing the value of those bonds (in Yuans) by the same percentage change.  How would you like to take a 25% hit on any of your investments?  The Chinese are facing just that probability.

So, what do they do about that???  Well, they don’t buy as many US Bonds in the future, but diversify their bond purchases to other currencies, like the Euro, Yen, etc.   And, if you kept up with this diatribe, here is the RUB.

When the Chinese purchase LESS US Bonds, the interest rate of our bonds will go up.  The reason we have been having such great interest rates over the past decade is that China has been purchasing lots of bonds.  As they buy bonds, the bond prices go up, and the bond interest rate falls.

So, we can look forward next year to higher interest rates caused by the Chinese.  How much??  Well, that depends on how many fewer US bonds the Chinese will purchase compared to past years.

So you thought this was an article about China???  Well, you were right, and wrong.  The world in tightly interlinked in its economies, and if China hiccups, we will hear it over here.

Here are Friday’s closing details:
DJ30 – 13,177 (Up 67 points)
10 year US Treasury Bond – 4.15%  (Down 0.01%) – another recent low in the interest rate = the next Fed Funds rate is built in.
Euro $1.4659
Gold closed at $787 per ounce.   No change
Oil Closed at $95.10 (Up $1.67)
Gasoline is $2.38  (Up $.04)