I was in the Third year of BMS and I had just read something about how the Yuan - pegged currency - is silently influencing world trade. I approached my professor with 2 topics for International Finance. And he preferred "Biofuel - Fuel of the Future"
Frankly, my knowledge about finance has evolved more because of my inclination towards it post Edelweiss rather than during or before that stint. I bestow this development on books, The Economist, The Mint, Bloomberg.com, BusinessWeek.com, MostlyEconomics.com (Special thanks to Amol Agarwal for creating a great site!) and my developed need to question matters. I have not mentioned conversations with people who are either experienced or knowledgeable - rarely both.
Reg. the Yuan
I have believed for quite a while that there is something very awkward going on in China.
1. PLRs are very low - relative to EMs and comparable to developed nations.
2. Inflation (CPI)is low - likewise.
3. Growth is mind boggling - relative to any country.
4. Currency is pegged - which in the past have caused inflationary, debt and/or BOP mishaps in other countries.
5. Massive Current Account Surpluses yoy.
6. Largest Forex Reserves in the world
Now - the way I function is that I ask questions.
1. Where does China put its money?
Answer - US Treasuries, Military ( defense ;-) ) expenditure, domestic infrastructure and overseas purchases (eg. African nations) through deemed PSUs, purchases of commodities - and hoarding.
2. Why Peg?
China - over the past 2 decades has grown as an - or rather 'the' - export powerhouse of the world. Unpegging or managed floating of the currency would allow the yuan to appreciate.
Thereby making the country relatively uncompetitive.
3. So what is the harm?
This question is a bit twisted; so let me use a hypothesis to explain.
Lower Exports => Lower international purchasing power => Hindrance to military and economic might.
Of course - I could add job losses, and lower demand to all of this.
People believed that China is 'rich' because it has more than USD 2 trillion in reserves.
But there was an interesting thought that said that China is in fact trapped because it is difficult for it to dump USD without causing an erosion in the value of USD. This makes complete sense to me - which is also why a month ago, China called for another global currency. In effect, China is currently stuck.
Currently - unpegging the Yuan ought to be beneficial to Foreign Investors and detrimental to China holding foreign assets.
Q. What would happen if China dumped its US treasuries?
A. My juvenile guess would be
1. An unwind of the dollar trade
2. Erosion of the USD value
3. Uncontrollable inflation in the US
4. Possible stagflation
5. Absolute mayhem in all assets including commodities - because most internationally traded assets are traded in USD
6. Flight to the Euro
Armageddon fascinates me - may be I might read this post in ten years and laugh at how wild my imagination was and vanilla my beliefs were.
Addendum - http://www.bloomberg.com/apps/news?pid=20601109&sid=aueh06DOY37A&refer=home
Something terribly flawed with the Chinese economy - that is my verdict.