QE2 and China

"QE2 worsens China’s currency dilemma

Whatever the effects of QE2 on the US, its impact on China will be major. Because China has attached its renminbi to the dollar, the ‘dollar economy’ consists of the US and China...

In this dollar economy, China is heavily undervalued (though nobody can assess by how much) and the US is overvalued. The Fed’s newly created liquidity could in effect “flow downhill” to the undervalued portion of the dollar economy. Already overheated, inflationary China will get a much larger dose of cost-push inflation in food and energy than the US.

Food is one third of China’s CPI, versus 14 per cent in America. This makes the recent 20 per cent rise in food commodity prices more important. Meanwhile, China’s competitive leg-up vis-à-vis Japan, Korea, Germany and others will be exacerbated by a further 5 per cent trade-weighted devaluation (in line with the dollar) - a currency impact that is likely to take effect much more quickly than any benefit from devaluation to the US. So higher Chinese inflation arising from QE2 is a double-whammy: demand-pull as well as cost-push.

...But QE2 shifts the emphasis heavily toward Chinese inflation, and potentially trashes the nest-eggs of the urban middle classes.

...because QE2-driven food and energy prices are actually liable to reduce US domestic demand over the next several months, there will be some malignant effects on China’s export business.

And when, next summer say, QE2 is seen not to have rescued the US from slow growth...the option of surcharging Chinese imports may seem the only action he can take.

“Double-whammy” scarcely does justice to the risks China faces."

Charles Dumas