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Why the Yuan is About to Slaughter the Greenback…Again

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Why the Yuan is About to Slaughter the Greenback…Again

Post by Sean on Fri May 16, 2008 6:50 am

Good day Currency Traders!

China's policymakers have one underlying fear right now: That China's economy will overheat. And for good reason - recently China's inflation soared to the fastest pace since 1996. Food prices have jumped 22% and overall consumer prices have rose 8.5% from just a year ago.

Usually economic growth is positive for a country. But when an economy grows too fast, too much cash flows into it. Then suddenly too much cash is chasing too few goods and you have inflation. Or in China's case, hyperinflation. And that can seriously damage an economy.

What are they planning to do about it? China's central banker gave some clues in his recent speech. First of all, he said China needs to cut its trade surplus to prevent excess cash from stoking inflation.

Turn China's Problems into Your Opportunity

What's one of the best ways to slow that surplus down? Raise the value of your currency. So you can bet that more yuan gains are on the way.

Recently, Chinese authorities made a stupid decision to slow down the yuan's appreciation. They wanted to discourage traders from speculating on their currency. In fact, they were so distracted by speculators that they ignored the rising inflation for a moment. And in doing so, they ended up stoking inflation even more.

So you can bet Chinese authorities have learned from that mistake (surely) and they'll allow the yuan to gain at a faster pace. As I mentioned, this is one of the few tools they have to cut the trade surplus. It's also an easier way to slow down the economy without raising interest rates further (which they appear reluctant to do).

However, the central bankers' reluctance to raise rates makes it even more likely that policymakers will use the yuan as their tool of choice to reduce that surplus.

After all, Chinese policymakers have already tried everything else to slow down the economy. But so far, it hasn't been enough. For instance, the central bank ordered their banks to set aside more money in reserves. This is the fourth time they've tried that trick this year. So now the banks have to set aside 16.5% of their funds as reserves.

The more the banks have to hold, the less they can lend. The less they can lend, the less businesses can borrow and expand, etc. So in theory, this should slow down inflation. But so far, it hasn't worked.

If China were growing at some meager pace, maybe this would do it. However, when you have monster inflation like they do, you've got to use every single weapon you have in your arsenal to fight inflation.

This is why I feel that the yuan will only continue to head higher. It's strengthened 4.5% against the buck so far this year and it strengthened 7% in 2007. Yet, I still believe the yuan will increase much more from here.

Let me put this another way. Consumer prices in China were supposed to grow 8.2% - less than the last reading of 8.3%. But the number came in at 8.5% and blew out the last reading as well as expectations for this reading. When that happens, you know the authorities will have to slam on the economy's brakes.

While China is raising reserve requirements and may have to raise rates again, they're definitely going to raise the value of the yuan in my opinion.

expect the chinese yuan to appreciate in the near term.


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