Question

In: Economics

Despite the ongoing trade war, China is one of the U.S.’s most important trading partners. (Consider...

Despite the ongoing trade war, China is one of the U.S.’s most important trading partners. (Consider how many goods are “Made in China”). What might happen to the value of the U.S. dollar, the U.S. economy, and the trade relationship between the two countries if China was experiencing unusually high inflation?

Your response should be approximately 2-3 brief paragraphs.

Solutions

Expert Solution

By loosely attaching the value of its currency, the yuan, to the dollar, China directly impacts the US dollar. China's central bank is using a modified version of a traditional fixed exchange rate that differs from the U.S. and many other countries ' floating exchange rate.

The Chinese People's Bank manages the value of the yuan. It keeps it fixed to a currency basket that reflects its trading partners. The basket is weighted against the dollar as China's biggest trading partner is the United States. It keeps the value of the yuan against that monetary basket within a range of 2 percent. In order to prevent inflation and future collapse, China's rulers must slow economic growth. Too much liquidity has been pumped into state-run businesses and banks. In turn, they have invested these resources in unprofitable enterprises. That's why the economy of China needs to reform or crash.

But as it slows development, China needs to be cautious. As some of these unprofitable companies shut down, China's rulers might generate panic. Bank loans support nearly a third of the economy in China. Nearly one-third of these loans are above the central government's lending boundaries. They're not in the books and they're not controlled. If interest rates increase too rapidly or if development is too slow, they could all default. A fine line must be followed by China's central bank to prevent a financial crisis.

The mega-rich of China would like to escape this danger. They invest as a secure haven investment in U.S. dollars and treasuries. The richest 2.1 million families control stocks, bonds, and real estate between $2 trillion and $4 trillion. In order to avoid more capital flight, China's rulers must be cautious to devalue the yuan. At the same time, it also can not hold the value of the yuan too high. This will slow the economy too much and just the same thing will cause capital flight.

China requires to be cautious with slowing development for another reason. In order to fuel their development, emerging market nations depend on exports to China. As the development of China slows, some of these trading partners will be harmed more than others. As the exports of these nations are slow, their development will be slow. As possibilities dry up, foreign direct investment will fall. Growth slowing weakens the currencies of these nations. Forex traders can use this trend to further push down currency values, further enhancing the dollar.


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