The Impossible Trinity

The Impossible Trinity

Is China attempting the impossible?

Temple of Heaven. Source: Photo Everywhere

This week the Chinese monetary authorities announced that they were dropping their Dollar peg. Instead, they want to tie their currency to a basket of global currencies—presumably the Euro and Yen. Good luck with that.

Currency pegs work until they don’t. The Dollar peg worked for the Chinese as long as the Dollar was falling. But the greenback started rising against the Euro and the Yen in 2011, and really took off when oil started to fall in 2014. Whatever the Chinese economy gained from falling oil prices they lost from a higher currency. So now they want to use a currency basket—in effect, devaluing the Yuan.

This won’t help. You can’t have a fixed exchange rate, free capital flows, and an independent monetary policy. Economists call this the “impossible trinity.” You can only have two of the three. Fixing the exchange rate too high or too low creates massive capital flows that overwhelm monetary policy. Giving up a sovereign monetary policy ties an economy to its more prosperous neighbor. That’s what the Euro-zone is—a fixed exchange rate among the its members, with monetary policy set by the Germans. This also creates regional pressures within Europe.

Impossible Trinity. Source: Wikipedia

The Chinese authorities are trying to shift their economy from being export-led to a consumer-led, service-oriented mix, and they’ve made tremendous progress. But everything takes time. The stronger Dollar—and stronger Yuan—are crimping China’s exports to Europe and Japan just as they shift to an inherently slower growth rate. But a basket won’t fix this. Only a free-floating currency can allow a country to balance the competing pressures of capital and trade flows. But the Chinese don’t think they’re ready for this.

This is what happened in 1998 with the Asian Contagion. Stability creates instability. Expect more volatility.

Douglas R. Tengdin, CFA

Chief Investment Officer

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