Who Says No One Rings a Bell?

Peter Schiff
July 21, 2005

The old saying "no one rings a bell," certainly doesn't apply today, as China rang the "mother of all bells." So deafening was its sound, that its vibrations will be felt around the world. Nowhere will the amplitude of these waves be more pronounced than in the United States.

China's decision to change the nature of its currency peg means that it will no longer be in the dollar buying business, or by extension, the U.S. Treasury buying business. That means that America will be losing its biggest benefactor. China will no longer act as the principal enabler of America's irresponsible extravagance, ending its subsidies to American consumers and borrowers.

Changing the nature of the yuan peg is a first step in the ultimate direction of either allowing the yuan to float freely or possibly pegging it to gold. In the meantime the yuan will remain undervalued, as it will likely be pegged to a basket of other currencies using current exchange rates that clearly undervalue the yuan. Chinese imbalances will continue to grow, along with all the domestic inflationary implications that result.

However, the pressure on China to prop up the dollar will be greatly diminished. To maintain the peg against its new basket, Chinese monetary authorities will most likely now be buyers of those other currencies likely to be included in its basket, such as the euro or yen. Since its reserves are already disproportionately held in dollars, it will likely rebalance those reserves to more accurately mirror the basket to which the Yuan will be pegged. Such a rebalancing will only exacerbate the dollar's decline. However, a declining dollar will not automatically require offsetting dollar buying by the Chinese as it has during the period of the yuan-dollar peg. As long as dollar weakness is offset by strength in others currencies in its basket, the peg can be maintained.

The implications for America are enormous. Far from being the panacea that American politicians proclaim, China's decision to alter its peg could be the pin that finally pricks America's bubble economy. For America, the direct result of this action will be the following:

1. Higher consumer prices.

2. Higher interest rates.

3. Reduced profits for American companies, particularly those dependent on domestic consumption and consumer debt.

4. Lower stock prices, as earnings decline and multiples contract.

5. The busting of the housing bubble, as tighter credit standards and higher interest rates squeeze current home prices.

6. Rising unemployment, as higher interest rates and vanishing home equity slow consumer spending and reduce jobs dependant on that spending.

7. A severe recession as a result of all of the above.

8. Rising federal budget deficits, as recession reduces tax revenue, while higher interest rates and escalating outlays increase expenditures.

In conclusion, July 21, 2005 will be another date likely to live in infamy. This time the aggressor is China not Japan, and the bombs are purely economic. Though there will be no immediate loss of life, and no American retaliation, the financial damages will be devastating. History will remember this date as the beginning of Chinese independence, and the beginning of the end of America's ability to depend on China.

Jul 21, 2005

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