Wednesday, May 25, 2005

Money Money Money

I don't think that China's currency is as undervalued as we have been led to believe, for the simple reason that there has been a conspicuous absence of speculation surrounding it. Currency pegs have to be maintained, in other words, if someone wants to buy 8.28 yuan for $1, the Chinese government has to do it. If they can't/don't, then the currency peg collapses and the currency will be revalued.

How does speculation influence this? If the currency peg is significantly different from its value, a speculator will try to profit from the difference. In the case of China, various funds and banks would begin establishing speculative positions--they would be buying yuan as fast as possible--in amounts ranging well into the billions of dollars. By increasing demand for the yuan, speculators would cause the value would go up, causing more people to sell dollars, increasing the demand still further, until the Chinese central bank did not have the resources to purchase more dollars. Thus the currency peg would collapse.

A speculative fund which purchased, for example, $10 billion at 8.28 to the dollar, could then sell it's holdings once the yuan revalued to, for example, 8 yuan/dollar for an extra $350 million. That's a profit worth risking the bank on. If the currency were revalued to, for example, only 8.26, the fund would make only $24 million.

Since there is a lack of speculation, we can deduce that the potential profits are not great enough to encourage massive speculative positions, meaning that the yuan, if revalued, will not change all that much--meaning that it is not terribly undervalued.


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