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Revaluations cause increased demand

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1 Revaluations cause increased demand on Thu Jul 08, 2010 10:48 am

windreader1


Revaluations cause increased demand
By Edward Lotterman
Updated: 07/07/2010 09:54:17 PM CDT

When the U.S. Postal Service announced that it is seeking to raise first-class postage to 46 cents, it placed itself in the same position China did when, a few weeks ago, it announced that it would let the value of its currency rise over time.

Announcing that something will rise in value in the future prompts people to buy it now while the price is lower. That complicates things for both the Chinese central bank and the USPS, although the problems facing the former are far deeper and longer lasting than the latter.

Think of a postage stamp as a special-purpose currency. That is not as far-fetched as it sounds. A dollar is a piece of paper that can be used to buy almost anything. A stamp is a piece of paper that pays for having a one-ounce letter delivered anywhere in the country.

When a nation takes deliberate actions to decrease the value of its currency relative to other nations' currencies, it is called a "devaluation." When it acts to increase the value of it currency it is called a "revaluation."

China announced that it will return to increasing the value of its currency, compared with the dollar. For many years it had been pegged at about 8.28 yuan per dollar. In July 2005, in response to U.S. pressure, it allowed the value of the dollar to sink, and thus that of the yuan to rise, so that by July 2008, it only took 6.8 yuan to buy a dollar. (Another way of expressing this is that the value of the yuan increased from 12.1 cents U.S. to 14.7 cents.)

20.7 percent increase in the dollar value of the yuan made Chinese goods more expensive in the U.S. and U.S. products cheaper in China.

But this gradual revaluation of the Chinese currency halted two years ago. The dollar still has greater value than it would if the exchange rate were left to pure market forces of supply and demand.

The exact degree to which the dollar is "overvalued" compared to the yuan is controversial, but estimates run in the range of 25 percent to 40 percent. This implies that the dollar should sink so that it takes 18-20 cents to buy a yuan instead of the current 14.7. (Quoted the usual way, it should take only 4.9 to 5.4 yuan to buy a dollar instead of 6.8.)

China has not announced how much or how fast it will allow the yuan to increase in value but the process will probably be slow unless it caves in to further international pressure. The USPS in contrast announced an exact 4.54 percent revaluation of first class postage, from 44 cents to 46 cents.

Since the USPS introduced the "Forever Stamp" in 2007, one can buy these pieces of paper now for 44 cents that will be worth 46 cents when and if the new rates go into effect. Expect people to buy a lot of these stamps in coming months.

And since the yuan also will increase in value in the future, investors face similar incentives to buy now. Someone who bought $1 million worth of Chinese currency in July 2005, could have sold it for slightly more than $1.2 million in July 2008. This would be in addition to any interest earned while the money was in yuan.

The increase in dollar value was not a great return, only 6.4 percent per year. But if you only put up $50,000 of your own money and borrowed the other $950,000 paying an interest rate in the same range as that earned in China, the return would have approached four times the $50,000 invested.

This is a variation of the classic "carry trade" in which one borrows in a country with low interest rates and invests in a country with high ones. The danger in the carry trade always is that the exchange value of the country in which you lend will drop relative to the country in which you borrow. In that case, even with interest, you may not get enough back to repay the loan you took out. But in the case of China in 2005, it was clear that the yuan would increase in value rather than decrease.

The same is true now, although the speed and extent of this increase remains unknown, for the precise reason of discouraging such speculative purchases of the yuan.

This is where the analogy between the "Forever Stamp" and the yuan diverges. If many people want to buy the stamp, the USPS can print as many of them as it wants. Increased demand won't drive up the value of the stamp beyond 46 cents.

But if international investors pour billions of dollars into China to benefit from anticipated currency revaluations, this will place further upward pressure on the price of the yuan. Like the postal service printing more stamps, the Chinese central bank can print more yuan. But such increases in its domestic money supply can bring negative consequences.

China wants to keep its currency cheap so that its exports remain cheap and employment in its export-oriented manufacturing industries high and social unrest low. It is revaluing reluctantly and it does not want any revaluation to become a self-reinforcing process. But this is not easy to manage. Once having gotten on the tiger of maintaining a sharply undervalued currency, dismounting again is not easy.

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