Renowned Danish economist LARS CHRISTENSEN writes a weekly column for Fréttablaðið, Iceland's most read newspaper and we publish an English version here at Iceland Insider. Christensen is specialised in international economy, emerging markets and monetary policy.
Recently the Chinese stock markets have plummeted and the jitters have spread to the global markets, and although some calm seems to have returned it is worthwhile reflecting on the roots of the recent turmoil. Here the tensions in what we might call the dollar bloc is absolutely central.
The ‘dollar bloc’ is the de facto currency union that for decades has been between the US and China (and Hong Kong and some others Asian countries and the oil-exporting Gulf states).
From 1995 to 2005, the Chinese renminbi was more or less pegged to the US dollar. From 2005 the renminbi was gradually and very controlled revalued against the dollar. This is essential continued until that Chinese authorities recently reversed course and recent conducted a series of minor devaluations.
China’s fixed exchange rate policy went well as long as the structural factors helped Chinese growth. The structural improvement in the Chinese economy should have led to a strengthening of the Chinese currency, but that was effectively prevented by the fixed exchange rate policy at least until 2005. The result was an undervalued currency and a booming economy. In the same period, the imbalances in the global economy also grew. Any Icelander knows that.
In other words, the combination of structural improvements and fixed exchange rate policy led to a too accommodative Chinese monetary policy, but from 2010-11 the story, however, has been turned upside down.
Thus, China is now facing serious major structural headwinds and with the prospect for a continued slowdown in Chinese growth the prospects for a strengthening of the China currency are also reduced. In fact there are good arguments for a weakening of the renminbi going forward. This will make it very difficult for the Chinese central bank to maintain the fixed exchange rate policy. The recent minor devaluation is a reflection of this.
This is also at the core of much of the market turmoil that we have seen recently and it is now becoming evident that the ‘dollar bloc’ is not what economists call an “Optimal Currency Area”. The Chinese and US economies simply are too different for a fixed exchange rate between the renminbi and the dollar to be maintained. And the same by the way can be said about other dollar ‘peggers’ in the world – for example the oil-exporting Gulf States’ fixed exchange rate polices are now increasingly under pressure due to sharply falling oil prices over the past year, which of course on its own is related to the Chinese slowdown.
China sooner or later must allow the currency to float freely. The process has now been accelerated by the weakness in the Chinese economy which should lead to a weaker Chinese currency, but also by the fact that the dollar has strengthened significantly over the past year as the US Federal Reserve has been moving closer to interest rate hikes.
Hence it is primarily a matter of time before ‘gold bloc’ will fall apart. This, however, should be celebrated rather than mourned, as the ‘dollar bloc’ was one of the main causes of the imbalances that were created in the global economy prior to the global financial crisis of 2008.
Renowned Danish economist LARS CHRISTENSEN writes a weekly column for Fréttablaðið, Iceland's most read newspaper and we publish an English version here at Iceland Insider. Christensen is specialised in international economy, emerging markets and monetary policy.
Recently the Chinese stock markets have plummeted and the jitters have spread to the global markets, and although some calm seems to have returned it is worthwhile reflecting on the roots of the recent turmoil. Here the tensions in what we might call the dollar bloc is absolutely central.
The ‘dollar bloc’ is the de facto currency union that for decades has been between the US and China (and Hong Kong and some others Asian countries and the oil-exporting Gulf states).
From 1995 to 2005, the Chinese renminbi was more or less pegged to the US dollar. From 2005 the renminbi was gradually and very controlled revalued against the dollar. This is essential continued until that Chinese authorities recently reversed course and recent conducted a series of minor devaluations.
China’s fixed exchange rate policy went well as long as the structural factors helped Chinese growth. The structural improvement in the Chinese economy should have led to a strengthening of the Chinese currency, but that was effectively prevented by the fixed exchange rate policy at least until 2005. The result was an undervalued currency and a booming economy. In the same period, the imbalances in the global economy also grew. Any Icelander knows that.
In other words, the combination of structural improvements and fixed exchange rate policy led to a too accommodative Chinese monetary policy, but from 2010-11 the story, however, has been turned upside down.
Thus, China is now facing serious major structural headwinds and with the prospect for a continued slowdown in Chinese growth the prospects for a strengthening of the China currency are also reduced. In fact there are good arguments for a weakening of the renminbi going forward. This will make it very difficult for the Chinese central bank to maintain the fixed exchange rate policy. The recent minor devaluation is a reflection of this.
This is also at the core of much of the market turmoil that we have seen recently and it is now becoming evident that the ‘dollar bloc’ is not what economists call an “Optimal Currency Area”. The Chinese and US economies simply are too different for a fixed exchange rate between the renminbi and the dollar to be maintained. And the same by the way can be said about other dollar ‘peggers’ in the world – for example the oil-exporting Gulf States’ fixed exchange rate polices are now increasingly under pressure due to sharply falling oil prices over the past year, which of course on its own is related to the Chinese slowdown.
China sooner or later must allow the currency to float freely. The process has now been accelerated by the weakness in the Chinese economy which should lead to a weaker Chinese currency, but also by the fact that the dollar has strengthened significantly over the past year as the US Federal Reserve has been moving closer to interest rate hikes.
Hence it is primarily a matter of time before ‘gold bloc’ will fall apart. This, however, should be celebrated rather than mourned, as the ‘dollar bloc’ was one of the main causes of the imbalances that were created in the global economy prior to the global financial crisis of 2008.
