3 Aug 2005

Fractal Butterflies:  Revaluing the yuan

by Steven Saus
Amid Chinese bamboo shoots, a butterfly flaps its wings.  Unnoted by any human observer, air currents change with the movement. Those changes alter other things: a breeze here, a bit of evaporation there.  Like reinforcing sine waves, the changes add up and a nor'easter - originally headed for Buffalo - slams right into New York City, burying it under snow.

This is the "butterfly effect", a thought experiment illustrating the mystery and beauty of chaos theory.  It illustrates that large, complicated results can occur due to small changes in initial conditions (Ross, Trager, Kraynak).  This branch of mathematics seems particularly applicable to economics, whose predictions are based on anticipating billions of individuals.  Sometimes, though, the butterfly isn't quite so obscure - and literally is in China.

On the 22nd of July, China moved to revalue its national currency, the yuan.  Beginning by raising the value of the yuan against the dollar, the yuan is now valued relative to a number of foreign currencies (Lim).  The "wind currents" of this wing flap will be felt worldwide -including New York.

Many desired this move to help solve our massive $124 billion trade deficit with China (Lim). Normally, the dollar would fall in value comparative to the yuan before the trade deficit became a problem (Barker).  With the yuan no longer "pegged" to the dollar, such an adjustment can occur. Our trade deficit with China is expected to decrease as goods produced in China become more expensive for U.S. consumers (Lim).  This will hurt importers like Wal-Mart as the rising costs of imports undermine the search for "Always Low Prices". China's rapid economic growth (largely due to massive exports to America) may slow even as Americans experience cost-push inflation.  The Federal Reserve is already working to curb increasing inflation (Reuters).

As the yuan increases in value, U.S. exports will become more competitive in the massive Chinese market. American manufacturing may even regain its footing by exporting to the very country that's most damaged it.  In turn, Chinese investors will be in a better position to buy publicly traded U.S. firms due to a strengthened yuan (Lim).  The manufacturing landscape in both countries is likely to undergo extreme changes in short order.

Much as most money is not in the form of actual currency, most of the "wind currents" will not be felt in the form of physical goods. (Mings, Marlin 261)
The Chinese economy has been undergoing rapid growth - 9.5% in the second quarter of this year (Lim).  This has driven increased foreign investment in China, a trend expected to increase with the new valuation of the yuan.  This leads many to fear monetary inflation in China (Barboza).  At the same time, there is a concern of Chinese divestment (or lessened purchases) of US treasury bonds.  If fewer dollars are purchased to support the yuan, then bond yields will rise, and end up leading to increased loan rates (Lim).

This may be the storm caused by butterfly wings.  Housing prices have been increasing at a dizzying rate in all developed economies - an increase totaling 100% of those countries' combined GDP (The Economist).  This rise in prices is concentrated in - but not limited to - metropolitan cities.  This boom has been driven by a lack of confidence in the stock market, and historically low interest rates.  (The Economist)  This rationale and the unprecedented rise in value indicate that this value increase is a "bubble", an overvaluation based on an expectation of further increases in price (Baker).  Talk of a housing bubble, earlier dismissed by the chair of the Federal Reserve, is now acknowledged as a possibility (Wolk).

This boom in real estate has helped prop up economies hurt by the bursting of the technology bubble at the turn of the century.  What recovery there has been - especially in America - has been largely due to consumer spending spurred by low interest rates on home mortgages (Wallace-Wells) Over 23% of American homes bought in 2004 were for investment, not owner-occupation. (The Economist).  American equity in homes was less than 55% in 2002 (Baker).  If the rapid rise in home prices reverses, that equity - intended as investment - will largely disappear, causing massive hardship and a probable rise in mortgage default rates (Baker).  Unfortunately, the bubble seems to have already burst in Australia.  While average house prices fell only 7% in two years, metropolitan Sydney saw value decrease by up to 16% (The Economist). If American homes were to devalue by similar percentages, consumer spending would fall and a recession would surely develop.
In the week before the yuan's decoupling from the dollar, the 10-year Treasury note yield jumped from 4.18% to 4.28% (Lim).  In the week since, as the yuan has risen 2%, the Treasury note yield has continued to rise, and the Fed is predicted to raise interest rates in an attempt to curb inflation (X-rates.com, Reuters).  The stage is set for mortgage rates to rise quickly and pierce the bubble's skin.

This possible train of consequences is apparently overlooked by mainstream business reporting.  The primary emphasis seems to be on the direct consequences on trade – which will probably not be a huge difficulty by itself (Swarts).  It is the second and third order consequences outlined above that may have huge consequences on the American economy.

If the butterfly's wings have moved just right, New York - and the rest of America's metropolitan areas - might not just get a nor'easter later this year.  They might just get a blizzard.

Works Cited

 Bought Love is a Salaried Position - Political Both Dreams and People Crash Down - Inspiration Shadows of the Spine - wierd and funny stuff Walking is the Process of Controlled Stumbling - religion Idle Thoughts Are Often True - The Work of Others Moments are the Measure of Our Lives - life under the microscope Newness is Relative - information overload Perceptions do not Limit Reality - miscellaneous This Space Intentionally Blank - free mail lists
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Bought Love is a Salaried Position - Political Both Dreams and People Crash Down - Inspiration From Unlikely Sources Shadows of the Spine - wierd and funny stuff Walking is the Process of Controlled Stumbling - religion Idle Thoughts Are Often True - The Work of Others Moments are the Measure of Our Lives - life under the microscope Newness is Relative - information overload Perceptions do not Limit Reality - uncategorized goodness This Space Intentionally Blank - free e-mail lists Some Rights Reserved