Sunday, February 22, 2009

Deflation & Exchange Rates

Anonymous wrote: "I was reading an article this morning that said that the Chinese will continue to buy our debt. I think the truth is that Chinese have decided to stop buying our debt. I wonder what this means to our $ against the other currencies."


It's an interesting question. In general and theoretically, deflation in a global economy has no affect on exchange rates. If Currency A was priced 1:1 with Currency B and you burn cash due to loans imploding with similar exposure across the globe, you can expect global interest rates to plummet near 0% as new cash becomes difficult to generate from existing cash. But exchange rates don't care:



If China is smart, they'll want to own more of our debt as interest rates fall. Like most things financial, it is counter intuitive but true that lower interest rates are more valuable than higher interest rates. In other words, a lower interest rate note (assuming market value) will pay you more stuff (value) over the life of the note.

China's existing U.S. debt is skyrocketing in value, because older notes continue to bear relatively high rates in a now-deflated environment. Every dollar promised is now worth much more.

10 comments:

  1. Great post FDR. However, this is an issue that concerns me. Since this crisis broke, China has been busy buying up foreign mineral reserves and oil reserves as well as cementing their position in Africa where they will presumably be flexing their economic muscle to the detriment of local populations. I think it's the degree of nationalist sentiment coming from China that is of most concern (I am certain I wouldn't feel as threatened if it wasn't for the fact that many Chinese I have associated with have put nation before anything else). These prolific breeders will soon run out of resources domestically and will be looking for alternatives. Where that may lead is anyone's guess.

    What should the US do in response? Well I've read many theorists influential in the US government sector who suggest the US' only recourse is to devalue the currency... Hmmmm

    By the way, what did you think of China?

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  2. The fact that the Chinese have refused to appreciate their currency has been a source of consternation to the US, Eurozone and UK as it is widely believed the remnimbi is undervalued giving them an unfair trade advantage. If this is indeed the case, it explains their astronomical growth over the past decade. Not that their growth hasn't been phenomenal; rather that it wouldn't have reached the same dizzy heights had the currency been allowed to naturally appreciate.

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  3. While I agree the Chinese are buying mineral rights and oil rights in various African countries. The Chinese often make it a requirement that they be allowed to import Chinese workers to do the work, instead of hiring local workers. This has resulted in a lot of friction between locals and the Chinese.

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  4. Economic imperialism - scary isn't it?!

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  5. FDR

    I would like your opinion. I understand your graphic on the money supply of various different nations, and how the exchange rate is matched by the relevant abundance of each currency. However, can you say something on supply and demand. For example, if the USA was to double its cash supply by just printing it, and country X did nothing. The fact still remains that the majority of assets around the globe are denominated in dollars, and right now, they are being cashed in. This puts the demand for dollars up greater to other currencies, and therefore leads to what is perceived as the current "strong" dollar. It matters not so much about the supply of money, but the demand for that currency at any particular time. Right now, people don't want houses, shares and assets, but they do need cash.

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  6. Thanks for the great illustration. I think I have discovered one of the main reasons why we are heading into the dark ages again. Academia teaches us "Assets = Liabilities + Owners' Equity". This means that the most indebted that can meet the minimum monthly payments wins. After all debt is an asset in the above formula. Basically I partake in the ponzi scheme also by acquiring debt and making minimum payments until one day the demand for full payments comes in. The problem is that I don't have that money as I only had the minimum monthly payments. After that the dark ages begin

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  7. Depends on how you present the formula, I like to look at it as

    Owner's Equity = Assets - Liabilities

    ReplyDelete
  8. Of course, neither are right, which is why they are taught by people who don't get finance or they would be rich instead.

    The correct equation is:

    Equity = PV(Assets) - PV(Liabilites)

    Where:

    PV(Liabilities) is forever-bound to yesterday's interest rates

    And

    PV(Assets) is risk-bound and can easily sink to near zero during deflation of the currency supply

    ReplyDelete
  9. As if PV isn't really PPrice. Economists as a group are hopeless confused about money. I've never met or read one, not one, with so much as a rudimentary understanding of how money works. Or even what it is.

    ReplyDelete

The USA's political-economc system is best described as:

On Nov 2, 2010, I plan to vote (FOR or AGAINST) my incumbent congressman

 
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