Tag: How to Speak Money

11 May, 2016

More to GDP Than What Just Media Talks About

Even if you are the kind who avoids reading business as well as economic news, you can’t avoid coming across the term GDP or Gross Domestic Product, time and again. If the GDP goes up at a fast rate, the economy is doing well. If the GDP doesn’t go up as fast as it is expected to, the economy is not doing well. And if the GDP contracts or falls, then god help us!

At least this is how the mass media talks about the GDP.

But what is the GDP? John Lanchester defines the term in How to Speak Money as: “The measure of all the goods and services produced inside a country.” It is a sort of a measure of the economic size of any country. Changes in GDP measure economic activity.

The trouble is that, at the end of the day it is a theoretical construct and there are problems with it. As Lanchester writes: “Many good things don’t contribute to GDP and many bad things do. The famous-to-economists example is divorce: when people get divorced they pay lots of lawyers’ fees. This adds nothing to anybody’s happiness except the lawyers’, but it adds plenty to the GDP.”

Then there is the problem of how to go about measuring the services part of any economy. As Diane Coyle writes in GDP—A Brief but Affectionate History: “The main input in a services business is the time spent by the employees on their job. What is the output of a teacher, though? Number of children processed through school? The average grade they attain on leaving? The highest subsequent qualification the children attain on average, or perhaps their lifetime earnings?”

Of course, these are not easy questions to answer. Then there are many other things that the GDP overlooks. As Rutger Bregman writes in Utopia for Realists: “Community service, clean air, free refills on the house – none of these things make the GDP an iota bigger. If a businesswoman marries her cleaner, the GDP dips when her hubby trades his job for unpaid work.”

The point being that GDP does not take into account unpaid work. As Bregman writes: “Or take Wikipedia. Supported by investments of time rather money, it has left the old Encyclopaedia Britannica in the dust – and taken the GDP down a few notches in the process.”

A lot of other unpaid work from cooking to babysitting to breast feeding children, which form a major part of daily lives, goes unmeasured as well. One reason for this might lie in the fact that a lot of the free unpaid work is carried out by women. As Coyle writes: “Generally official statistical agencies have never bothered – perhaps because it has been carried out mainly by women.”

Further, GDP does a very bad job of measuring advances in knowledge and technology. As Bregman writes: “Our computers, cameras and phones are all smarter, speedier and snazzier than ever, but also cheaper, and therefore they scarcely figure. Where we still had to shell out $300,000 for a single storage gigabyte 30 years ago, today it costs less than a dime.” Also, free products like Skype, which make our lives a tad easier, lead the GDP to contract.

Also, it is worth remembering that any sort of destruction adds to the GDP. As Lanchester writes: “Your house has just burnt down, and you’ve lost everything. That’s too bad; on the other hand, it’s great for GDP, because you’re going to have to rebuild it and re-buy all your stuff.”

This is precisely what happened to Japan after the Sendai seaquake in March, 2011. The total damage estimated by the World Bank was estimated to be around $235 billion. Nevertheless, things soon started to improve.

As Bregman writes: “After a slight dip in 2011, the following year saw the country’s economy grow 2%, and figures for 2013 were even better. Japan was experiencing the effects of an enduring economic law which holds that every disaster has a silver lining – at least for the GDP.”

The point being, there is a lot more to the GDP, than the media talks about.

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The column originally appeared in the Bangalore Mirror on May 11, 2016

4 November, 2014

Federal Reserve ends money printing, but the easy money party will continue

Vivek Kaul

The Federal Open Market Committee(FOMC) which decides on the monetary policy of the United States in a statement released yesterday said “the Committee [has] decided to conclude its asset purchase program this month.”
What the Federal Reserve calls “asset purchase program” is referred to as “quantitative easing” by the economists. In simple English this is just the good old money printing with a twist. Since the start of the financial crisis, the Federal Reserve has printed around $3.6 trillion of new money.
This month the Federal Reserve has printed around around $15 billion. It has pumped this money into the financial system by buying government bonds and mortgage backed securities. From November 2014, the Federal Reserve will no longer print money to buy government and private bonds.
So why is the Federal Reserve bringing money printing to an end? The simple reason is that with so much money being printed and pumped into the financial system, there is always the threat of too much money chasing too few goods, and leading to a massive price rise in the process. Even though something like that has not happened the threat remains.
As John Lanchester writes in How to Speak Money “More generally QE[quantitative easing] taps into the fear that governments printing money always leads to dangerous levels of inflation, and that inflation, like a peat-bog fire, is all the more dangerous when it’s cooking up underground.”
There have been too many instances of money printing by the government leading to massive inflation in the past. And the Federal Reserve couldn’t have kept ignoring it.
Lanchester perhaps describes quantitative easing(QE) in the simplest possible way and what it really stands for by cutting out all the jargon in his new book How to Speak Money. As he writes “QE involves a government buying its own bonds using money which doesn’t actually exist. It’s like borrowing money from somebody and then paying them back with a piece of paper on which you’ve written the word ‘Money’ – and then, magically, it turns out that the piece of paper with ‘Money’ [written] on it is actually real money.”
Lanchester describes QE in another way as well. He compares it to a situation where an individual while looking at his “bank balance online” also has “the additional ability to add to it just by typing numbers on [his] keyboard.” “Ordinary punters can’t do this, obviously, but governments can; then they use this newly created magic money to buy back their own debt. That’s what quantitative easing is,” writes Lanchester.
This has been done in the hope that with all the newly money created being pumped into the financial system, there would be enough money going around and interest rates would continue to remain low. At lower interest rates the hope was people would borrow and spend more, and this in turn would lead to economic growth.
This did not turn out to be the case. What happened instead was that financial institutions borrowed money at very low interest rates and invested that money in financial markets all over the world. This explains to a large extent why stock markets have rallied all over the world in the recent past despite slow economic growth in large parts of the world.
So with the Federal Reserve deciding to stop money printing, will the era of easy money come to an end as well? The answer is no. For “easy money” junkies the party will continue. The Federal Reserve stated yesterday that “The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial condition.”
What does this mean in simple English? The Federal Reserve has printed and pumped money into the financial system by buying bonds. It currently holds around more than $4 trillion worth of bonds. Bloomberg points out that this makes up for around 20% of all the bonds issued by the American government as well as mortgage backed securities outstanding. The Federal Reserve holds around $2.46 trillion of US government bonds.
In the days to come as these bonds mature, the Federal Reserve plans to use the money that comes back to it to buy more bonds. In this way it plans to ensure that the money that it has printed and pumped into the financial system, stays in the financial system.
Hence, Federal Reserve will not start sucking out all the money it has printed and pumped into the financial any time soon. And this means that the era of “easy money” will continue for the time being. The Federal Reserve also stated that fit plans keep interest rates low “for a considerable time following the end of its asset purchase program this month.”
By doing this, the Federal Reserve is essentially buying time. Currently, it is very difficult to predict how exactly the financial markets will react if the Fed decides to start sucking out all the money that it has printed and pumped into the financial system.
As Lanchester writes “Nobody quite knows what’s going to happen once QE stops. In fact, the ‘unwinding’ of the QE is on many people’s list as the possible trigger for the next global meltdown.” Further, even though the American economy is doing much better than it was in the past, the recovery at best has been fragile. The US economy grew by 4.6% during the period between July and September 2014, after having contracted by 2.1% during April to June, earlier this year.
The rate of unemployment in the US has been coming down for quite a while now. In September 2014, it stood at 5.9% against 6.1% in August. This rate of unemployment is around the average rate of unemployment of 5.83% between 1948 and 2014. It is also below the 6.5% rate of unemployment that the Federal Reserve is comfortable with.
Nevertheless, even with these reasons, the Federal Reserve is unlikely to start sucking out money and raising interest rates any time soon. This is because the US has become what Lanchester calls a “two-speed economy”. Lanchester defines this as “an economy in which different sectors are performing differently at the same time”. In the American context, it is a matter of Texas and the rest of the country.
The state of Texas has been creating more jobs than any other state in the United States. As Sam Rhines an economist at Chilton Capital Management points out in a recent article in The National Interest “From its peak in January 2008 through today, the United States has created only 750,000 jobs. Texas created over a million jobs during that same period—meaning that the rest of the country (RotC) is still short 300,000 jobs. During the recovery, job creation has been all Texas or—at the very least—disproportionately Texas.”
This has meant that the contribution that Texas has been making to the US economy has increased over the last few years, from 7.7% in 2006, it now stands at 9%. So, if one takes Texas out of the equation, the United States still hasn’t recovered all the jobs it lost since the start of the financial crisis in September 2008. Further, if one takes out the Texas growth out of the equation, the GDP growth also falls considerably. As Rhines writes “From 2007 through the end of 2013, the U.S. economy grew by $702 billion, and Texas grew by $220.5 billion.”
Other than this the broad unemployment numbers hide the fact that the labour force participation rate has been falling over the years. Labour force participation rate is essentially the proportion of population older than 15 years that is economically active. The number for September 2014 stood at 62.7%. This is the lowest number since 1978. The number had stood at more than 65% before the start of the financial crisis. Hence, more and more people are now not looking for jobs and they are no longer counted as unemployed.
Further, a lot of jobs being created are part-time jobs. Also, with jobs being difficult to come by many people looking for full-time jobs have had to take on part time jobs. In August 2014, nearly 7.3 million Americans were involuntarily working part time, compared to 4.6 million in December 2007, before the financial crisis had started. In September 2014, this number dropped to 7.1 million. Even after this fall, the number remains disproportionately high. This underemployment is not reflected in the rate of unemployment number.
Janet Yellen obviously understands this. As she had said in a press conference in September 2014 “There are still too many people who want jobs but cannot find them, too many who are working part-time but would prefer full-time work.”
Taking all these factors into account the Federal Reserve is unlikely to start sucking out all the money it has printed and pumped into the financial system any time soon. Nevertheless, whenever it gets around to doing that there will be trouble ahead.
Lanchester perhaps summarises the situation well when he says: “If a medicine is guaranteed to make you very sick when you stop taking it, and you know that one day you’ll have to stop taking it, then maybe you shouldn’t start taking it in the first place.”
But that at best is a benefit of hindsight. The horse, as they say, has already bolted by now. Alan Greenspan, the former Chairman of the Federal Reserve, recently said that the next phase of Fed’s retreat would not be so smooth and the Fed would not able to avoid turmoil. “I don’t think it’s possible,” Greenspan said.

The column is an updated version of a column that appeared on October 29, 2014. You can read it here.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

20 October, 2014

Reversification: A one-word explanation for what’s wrong with the world of finance

Vivek Kaul

When MTV first came to India in the early 1990s, I was hooked on to the channel in a matter of a few months. Growing up in a small town, the channel was my first “real” exposure to what we called “English” music. Until then my only exposure to English music was “Michael Jackson” and like others of my generation I was more aware of his mannerisms than his songs.
One of the things that got me hooked to MTV was reggae music. And one of the first reggae songs that I heard was Inner Cirlce’s Games People Play. Other than the music of the song which was very peppy, what I liked was that for the first time I was able to make out the lyrics of an English song.
One paragraph of the song went like this:
Oh the games people play now
Every night and evety day now
Never meaning what they say, yeah
Never saying what they mean.
This paragraph has stayed with me since then and I have realized its meaning in various contexts at various points of time over the last two decades. One area where this paragraph particularly applies is finance. The writer John Lanchester in his new book How to Speak Money comes with a new term to explain this . He calls the term “reversification”. He defines reversification as a “process in which words come, through a process of evolution and innovation, to have a meaning that is opposite to, or at least very different from, their initial sense.”
A good example of reversification in finance is the much used term “Chinese wall”. In real life, the Great Wall of China is a very big wall that was built over several centuries to keep the enemies out of China. One of the biggest misconceptions about it is that it is visible from the moon.
So, what does it mean in finance? “Inside the world of money, though, the term ‘Chinese wall’ means an invisible barrier inside a financial institution which is supposed to prevent people from sharing information across it, in order to avert conflict of interests,” writes Lanchester.
Let’s take the example of the Chinese walls that are supposed exist between stock analysts who make investment recommendations to investors (i.e. whether to buy, sell or hold the stock of a company) and the investment banking division, which takes companies public, by getting them listed on a stock exchange.
This wall is regularly broken whenever a profitable investment opportunity comes up. Take the case of the dotcom bubble in the United States in the 1990s.
Even with many internet firms wanting to go public, Wall Street still wasn’t in a bargaining position. The bargaining power was with the 20–30 year olds, who ran most of these new internet companies, or the Silicon Valley venture capitalists (VCs) who had backed them. The youngsters and the VCs did not ask for a cut in Wall Street’s fee. What they wanted instead was an assurance that the Wall Street firm would support the price of the stock after it had been listed on the stock exchange.
And, of course, this had to be done legally. This was important for the Wall Street firms because new companies wanting to come out with their IPOs looked at this parameter before choosing the Wall Street firm which would handle its public offer.
The way Wall Street handled this was very clever. Before going public, the Wall Street firm promised the company that the in-house analyst of the firm would initiate coverage of the stock a few days after it got listed on the stock exchange. No favourable coverage or for that matter, a “buy” rating was promised because that would have been going against the law. It was assumed that the Wall Street firm would have nice things to say about the company it had just taken public. And so the Chinese wall was broken. Even in India, it has been observed that the stock broking division of a financial institution has nice things to say about a company that has just been taken public by the investment banking division of the same financial institution.
The way the financial system has evolved large financial institutions have different businesses which “if the system is to function without conflicts of interest – shouldn’t really be there.” But that is not the case. Hence, as Lanchester puts it “the Chinese walls…were worse than non-existent; they were opportunities for the bank to make money…that’s reversification.”
Another excellent example of reversification is a hedge fund. As Lanchester writes “the word ‘hedge’ began its life in economics as a term for setting limits to a bet, in the same way that a hedge sets a limit to a field…The idea is that by putting a hedge around a bet, you delimit the size of your potential losses.”
But is that the case? Before we get into that let’s try and understand what really is a hedge fund. Legally, there is no term called a “hedge fund,” unlike, say, “mutual fund.” The term “hedge fund” was apparently first used by the Fortune magazine in a 1966 article to describe an investment fund managed by Alfred Jones, a Columbia University sociologist, diplomat and steamboat purser who had turned into a fund manager. The article had a very interesting title. It was headlined “The Jones Nobody Keeps Up With”.
In 1952, Jones wanted to launch an investment fund which would not only buy stocks on which he was bullish on, but also short-sell the stocks (i.e., borrow and sell) which he felt were overpriced and, thus, would fall in price in the days to come. At the same time, he thought that with the expertise he brought to the table, the investors in the fund should be willing to pay him a slice of the profits he made for them.
Jones wanted to buy as well as short-sell stocks. The money that he generated from short-selling stocks would partially fund the buying of stocks which he felt were undervalued. This way, he ensured that the exposure was “market neutral,” or, in a simpler language, he “hedged his bets.”
The strategy of Alfred Jones of buying some stocks and selling some others came to be known as the equity long-short strategy. He outperformed the mutual funds which could only go long, that is, buy stocks. They could not sell them short because it was deemed to be a risky strategy. Jones also used leverage, that is, borrowed money, to spruce up his returns. Jones received 20 percent of the returns he generated for the fund as compensation.
The success of Alfred Jones was copied by many others. “The classic hedge fund technique, as created by Jones, is still in use: funds employ complex mathematical analysis to bet on prices going both up and down in ways which are supposedly guaranteed to produce a positive outcome,” writes Lanchester.
But is that really the case? A majority of the hedge funds fail. As Lanchester points out “90% of all hedge funds that have ever existed have closed down or gone broke. Out of total of about 9,800 hedge funds worldwide, 743 failed or closed in 2010, 775 in 2011, and 873 in 2012 – so in three years, a quarter of all the funds in existence three years earlier disappeared. The overall number did not decrease, because hope springs eternal, and other new hedge funds kept being launched at the same time.”
This is reversification at its best, where the word ‘hedge’ has been turned into exactly opposite of what it originally meant.
Another excellent example of reversification is securitization, which has “nothing to do with making things more secure.” Let’s try and understand this step by step.
A big financial institution sells financial securities and raises money. The money is used to buy home loans or mortgages from banks. These home loans are then pooled together. The people who have taken these home loans pay interest on these loans as well as repay their principal. This money comes into the common pool. From this pool, the financial institution pays interest on the securities it has sold to investors. It also repays the principal out of it. This process is referred to as securitization.
In the days when banking was a boring business, banks lent out the money they had collected from deposits. They also kept the loans on their books till they matured. They made money as long as the interest they paid on their deposits was less than what they charged on their loans,a ssuming that the borrower did not stop repaying.
But with securitization the bank does not maintain the loan on its books any more. It passes on the risk to the investor who buys the securities being issued. As Lanchester puts it “It[i.e. the bank] only takes the RISK of the loan for the amount of time between making the initial house loan, and the moment when it has sold the resulting security – which can be a matter of days. The bank has no real interest in the financial condition of the borrower. The basic premise of banking – that you only lend money to people who can pay it back – has been broken.”
Hence, the bank is more interested in giving out home loans rather than verifying whether the borrower has the capability to repay. This was a major reason behind the current financial crisis which started in September 2008.
Lanchester in coining “reversification” has come up with a term which explains a lot of what is wrong in finance. The examples discussed above clearly show that. As Lanchester writes “These are all examples of how process of innovation, experimentation and progress in the techniques of finance have been brought to bear on language, so that words no longer mean what they once meant.”
And this has created a major problem. “It is not a process intended to deceive…But the effect is much the same: it is excluding and it confines knowledge to within a priesthood – the priesthood of people who can speak money,” concludes Lanchester.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

2 October, 2014

Get ready for a real mess: A new chapter may be opening in currency wars

Vivek Kaul

The Japanese yen recently touched a six year low against the dollar. One dollar is currently worth around 108-110 yen. This many experts believe will lead to the start of a new round of currency wars. As Albert Edwards of Societe Generale writes in a recent research note dated September 22, 2014 “the yen has slipped below a key 15-year support level against the dollar…The next phase of global currency wars may have begun.”
The term “currency war” was first used by Guido Mantega, the Brazilian finance minister, in 2010. It refers to a situation where multiple countries start driving down the value of their currencies against the dollar in a bid to drive up exports and inflation.
Before we try and understand Edwards’ statement in detail, it is important to go back a few years. The Bank of Japan joined the money printing party rather late in the day towards the end of 2012. Before this the balance sheet of the Japanese central bank had expanded only 30% since the start of the financial crisis. Interestingly, in January 2012, the total assets of the Japanese central bank had stood at 128 trillion yen. Since then, it has more than doubled to 275.9 trillion yen at the end of August 2014.
The Bank of Japan plans to inject $1.4 trillion into the Japanese financial system by April 2015 by buying Japanese government bonds every month. This is pretty big, given that the size of the Japanese economy is around $5 trillion. Currently, it is printing 5 trillion yen every month and pumping that into the financial system by buying bonds. That explains why the total assets held by the bank have more than doubled.
The Bank of Japan entered the money printing party only after Shinzo Abe was elected as the prime minister on December 26, 2012. Abe promised to end Japan’s more than two decades old recession through some old fashioned economics, which has since been termed as Abenomics.
Abenomics is nothing but money printing in the hope of driving down the value of the yen against the dollar in the hope of increasing exports and also creating some inflation.
As James Rickards writes in The Death of Money “Japan…had another reason to support the money printing…Money printing was being done not only to promote exports but to increase import prices. These more expensive imports would cause inflation to offset deflation…In Japan’s case, inflation would primarily come through higher prices of energy exports.”
The Bank of Japan decided to get in bed with the government on this and is targeting an inflation of 2 percent. It wants to reach the goal at the earliest possible date. And how does that help? In December 2012, Japan had an inflation rate of –0.1 percent. For 2012, on the whole, inflation was at 0 percent, which meant that prices did not rise at all. In fact, for each of the years in the period 2009-2011, prices had fallen in Japan.
When prices are flat, or are falling, or are expected to fall, consumers generally tend to postpone consumption (i.e., buying goods and services) in the hope that they will get a better deal in the future. This impacts businesses, as their earnings either remain flat or fall. This slows down economic growth.
On the other hand, if people see prices going up or expect prices to go up, they generally tend to start purchasing things. So a moderate inflation helps businesses as well as the overall economy. Hence, by trying to create some inflation the idea is to get consumption going again in Japan and help it come out of a more than two decades old recession.
The money printing has helped create some inflation in Japan. In July 2014, the consumer price inflation in Japan stood at 1.3%. One reason for this rise has been the fall in the value of yen against the dollar. In early November 2012, one dollar was worth 79.4 yen. Currently, one dollar is worth 108-110 yen, as mentioned earlier. This has made imports expensive and pushed up inflation. As John Lanchester writes in his new book How To Speak Money “The yen has dropped, which is a good thing for Japanese industry, and inflation is showing signs of returning, which is also a good thing, though some commentators are worried that the process could quickly go out of hand.”
The question here is how can the process quickly go out of hand? Allow me to explain. The inflation hasn’t led to people spending more money. In fact, the gross domestic product (GDP) of Japan contracted at an annualized rate of 6.8% during the three month period of April to June 2014. It was also expected that a falling yen will boost Japanese exports. But that doesn’t seem to have happened either. Exports have fallen in three out of the last four months. In August 2014, exports fell by 1.3%, in comparison to the same period last year.
Interestingly, one of the key learnings in the aftermath of the financial crisis has been that if a policy does not work for a central bank, it is likely to try more of it. Given this, it is expected that the Bank of Japan will print more money in the hope of inflation reaching the targeted 2% and to get exports going as well. Diana Choyleva, head of macroeconomic research at Lombard Street Research, writes in a research note that the Bank of Japan “is also likely to redouble its QE [quantitative easing] efforts if it is to achieve its 2 percent inflation target.”
This will lead to further depreciation of the yen against the value. As Edwards of Societe Generale puts it “One of the few things I have learnt over 30 years in this industry is that when traders decide the yen/US$ starts to move it can jump by Y10 or Y20 very, very quickly indeed.”
In this scenario other countries are also likely to print money so that their currencies lose value against the dollar, in order to keep their exports competitive. The thing to remember here is that money printing in the hope of driving down the value of currency is not something that only Japan can indulge in. Interestingly, this is precisely what had happened when Japan first made its first moves towards printing money in December 2012.
In fact, politicians in South Korea by early February 2013 had started voicing their concerns about the depreciating yen. South Korea and Japan compete in several export-oriented industries, like automobiles and electronics. Korean export companies like Samsung and Hyundai compete with Japanese companies like Sony and Toyota.
At the end of December 2012, one dollar was worth 1,038.1 Korean won. Soon, the Korean won also started depreciating against the dollar, and by late June 2013, one dollar was worth around 1,160 Korean won. The Thai baht started depreciating against the dollar in April 2014. The Malaysian ringitt joined the club from May 2013 onward. By early 2014, China had also entered the currency war by allowing the yuan to depreciate against the dollar.
Nevertheless, the depreciation of this currencies against the dollar did not continue. The South Korean won is back to where it started and currently quotes at around 1063 won to a dollar. But there is nothing that can stop these countries from starting to cheapen their currencies against the dollar, all over again. The currency wars might break out all over again.
The joker in the pack is China. Currently, one dollar is worth around 6.14 Chinese yuan. It is interesting to look at the trajectory of the Chinese yuan over a period of time. In 2005, one dollar was worth around 8.27 yuan. By 2011, one dollar was worth around 6.82 yuan. The appreciation of the yuan against the dollar continued at a measured pace and by mid-January 2014, one dollar was worth 6.14 yuan. This is when things turned around and the yuan started to depreciate against the dollar, something that had not happened in a very long time. By April 30, 2014, one dollar was worth 6.25 yuan.
Among other things the depreciation of the yuan was also a response to Abenomics which had led to the depreciation of the yen against the dollar. One dollar was worth around 80 yen in November 2012, before Shinzo Abe had taken over as the Prime Minister of Japan. By January 2014, one dollar was worth 105 yen, thus making Japanese exports more competitive in the international market. China’s yuan had to be adjusted to this new reality. As China is trying to move up the value chain, its products are competing more and more with Japanese products in the international market.
Nevertheless, since June 2014, the yuan has been appreciating against the dollar. But if the Japanese keep printing money and driving down the value yen against the dollar, the Chinese are also likely to have to start pushing the yuan down against the dollar.
This would mean Chinese exports more competitive. As the yuan depreciates against the dollar it would allow Chinese exporters to cut prices of their products. Let’s understand this through an example. A Chinese exporters sells a product at $100. He ends up getting paid 614 yuan for it, at the current rate. But if one dollar is worth seven yuan, he would be paid 700 yuan. This situation will allow the Chinese exporter to cut the price of his product. Let’s say he cuts it to $90, even then he ends up earning 630 yuan ($90 x 7), which is more than earlier.
As Choyleva of Lombard Street Research, writes in a recent research note “If both Japan and the euro area go for extensive QE, emerging markets in Asia would suffer as their currencies appreciate. There would be no way China could restart its sputtering growth engine without major yuan devaluation.”
In order, to stay in competition, prices of products from other countries will have to be cut. And this will end up exporting deflation (a situation where prices are falling) to large parts of the world. Of course, it is worth remembering here that everybody cannot have the cheapest currency. Once countries start devaluing their currencies, it becomes a race to the bottom and is not good for anyone. In technical terms this is referred to as beggar thy neighbour policy.
As a senior official of the Federal Reserve once remarked: “Devaluing a currency is like peeing in bed. It feels good at first, but pretty soon it becomes a real mess.”

The article originally appeared on www.FirstBiz.com on Oct 2, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)