China's Currency Regime Shift Will Ultimately Be Deflationary

The knee jerk reaction to this weekend's announcement out of China is that it's a green light to take risk. To the extent that Chinese acquiescence on its currency policy might derail the growing protectionist momentum within the US Senate, the move higher in asset prices today is justifiable.

But a deeper dive into the implications of a stronger RMB reveals that running headlong into risk may be exactly the wrong reaction. Over the past decade or so, many developing countries have either implicitly or explicitly pegged their currencies to the US dollar. As a result, the foreign exchange reserves of these nations grew by an eye-popping $6 trillion since 2002, a 300% increase. Most of those reserves have been recycled back into western bond markets which has artificially suppressed interest rates and facilitated credit growth well in excess of any logical equilibrium.

Even as the Chinese allowed for modest appreciation of their currency from 2005 to 2008, the gains were simply not large enough to correct trade imbalances or discourage speculative inflows. China's FX reserves continued to grow throughout this period.

In total, this decade-long phenomenon almost entirely explains the credit and housing bubbles that developed in the US and Europe. Moreover, during the past year, growing FX reserves combined with quantitative easing provided cover for already overly-indebted nations to ease the pain of the bubbles' bursting by leveraging up pubic sector balance sheets.

The end result is that with quantitative easing over, the excessive leverage in the developed world will require continued inflows of foreign capital in order to remain sustainable. Therein lies the fly in ointment of a stronger RMB.

The 2009 global recession has caused China's heretofore large trade surplus to dwindle to generational lows and incremental gains in the RMB will likely eliminate the surplus altogether. Additionally, the stronger the RMB becomes, the less artificially undervalued it will be - eventually this will discourage speculative flows into China.

As the US dollar approaches a true equilibrium versus the RMB, FX reserve accumulation will slow and ultimately stop. At that point, the artificial subsidy to the US bond market that recycled reserves created will be gone. All else equal, real rates will be higher and asset prices will be lower creating a highly deflationary economic scenario.