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October 28, 2010

U.S. and China currency deal?

Behind the scenes, China and the U.S. may already have struck a currency agreement, said Douglas Borthwick, head trader of Connecticut-based Faros Trading.

Borthwick thinks China and the U.S. may have agreed to gradually appreciate the Chinese yuan over 5 years. This could occur at an average annual rate of 7.8 percent, which would amount to 40 percent at the end of 5 years. Western academics estimate the yuan is currently 30 to 40 percent undervalued.

NOTE: An increase of 40% in the yuan will not mean a 40% increase in China's product prices. Higher currency rate will lower the cost of oil and other input materials and whatever else they buy, so prices might go up by 1.4 times what is value added inside China.





It is different from the 1985 Plaza Accord, in which leading countries openly agreed to revalue currencies and the Japanese yen rallied over 50 percent in against the U.S. dollar in just two years.

The U.S.-China currency war, therefore, may be a protracted five-year struggle. During this constant tug-of-war, the U.S. will push for faster appreciation and China will push back.

One weapon the U.S. has is quantitative easing, which is theoretically unlimited. When it is employed, it floods China with capital, which makes it harder to keep the yuan's value down.

Analysts believe the Federal Reserve will employ a flexible quantitative easing program in which the amount of assets purchased can be adjusted each meeting. Borthwick said this structural allows "gentle prodding" from the U.S., which can step up asset purchases whenever it feels yuan appreciating is progressing too slowly.

The yuan appreciating 40 percent against the U.S. dollar may go a long way in rebalancing the global economy. Borthwick said in the five-year period, the U.S. can rebuild its export sector and China can build domestic demand and financial markets

The results of the 1985 Plaza Accord serves as a somber warning. The agreement did achieve its objective of depreciating the dollar against the Japanese yen; however, not only did it fail to solve the United States' trade deficit problem, it also hurt Japan's economy

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