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October 17, 2007


Bond investor

ZB, another good post, but missing a couple points, I think:

1. You assume the CNY and USD will be pegged in perpetuity. The slow revaluation of CNY over the past two years suggests otherwise. Its slowness is specifically designed to avoid a "George Soros vs. Bank of England" repeat.

2. You cite as an identity that U.S. investors owning U.S. stocks doing business in yuan is equivalent to Chinese investors owning Chinese stocks doing business in yuan. Chinese investors have only very, very recently been allowed to invest *any* capital offshore. Chinese firms trading on the Shanghai and Shenzen exchanges (closed to foreign investors) are at whopping premia to supposedly identical shares trading in Hong Kong. Meanwhile, the Chinese have an extremely high savings rate, but they still (despite the bubbly stock markets) predominantly save in bank deposits, which must be invested in government bonds, which allows for more accumulation of currency reserves.

3. You neglect an important factor in considering your "dollar goes to zero" scenario. Foreigners own a tremendous amount of U.S. debt, predominantly in Treasuries, but also hundreds of billions in agencies and even corporate bonds. All of this debt is denominated in -- U.S. dollars! So a "dollar goes to zero" scenario also wipes out the foreign reserves. Think that'll happen?!? And what would the effects be? Note this is an important difference from when the U.S. was in debt up to an estimated 100%-plus of GDP in the 1890s. Back then, our debt was denominated in francs, pounds sterling and deutschemarks. Today, we can just inflate or devalue away our debt. Not a pretty "solution," but one that hurts the foreigners more than it hurts the U.S. consumer.

Zero Beta

Thanks for the feedback. First off, in this post I tried to steer clear of interpreting anything beyond the actual dynamics and relationships. Any examples were just that examples, probably regarding China, I chose a poor example In response to your points...

1. I believe because of the peg, we have had to keep the dollar low - hence rising M3, etc. Therefore, although the Yuan/USD cross hasn't moved, the excess dollars have floated elsewhere. When the peg is lifted and the Yuan appreciates, it will not only do this against the dollar. There will be more of a redistribution of dollars as the system reaches some sort of equilibrium. Therefore, different measures of dollar indexes will change by different degrees. The trade weighted index will be different than G10 index. I think the yuan is overvalued because of dollars, but may be very undervalued against the Euro.

2. That was a poor example. I just tried to illustrate the idea of covered interest rate parity. You are right. I agree that in reality this is not the case, but may be offset by the yuan peg.

3. Note, I did not say go to zero but "approach" zero. It is the approach to zero or the approach to infinity that makes functions behave strangely as they never reach either. In reality the dollar CAN equal zero. Since a line can not gain conciousness while travelling on a plane, this will never happen in mathematics, but a market can - they can essentially shape their own critical points. If this path continues like it has without hitting some sort of critical point (which is what you mention above), then yes it could be zero, but some sort of intervention is more likely.

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