Central Bank problems - US investments, growth v/s inflation, Exchange rate hurdle

I am hearing repeated instances of global central banks now focussing on growth. Earlier, amdist the whirlwind shock wave of global economic downturn and rising oil prices, central bankers chose to slow the economy with a use of lagged monetary policy instruments. Now as oil and commodity prices subside, central banks look to fan the growth fires again. I believe most of it is a farce. Particularly so in case of China. Brad DeLong links to James Fallow's take on China in two parts first part and second part here. I think James Fallow has mis-interpreted the situation.

Formula economics
Emerging economies learnt the formula for growth in the past decade. It involved promoting investment and job creation, encouraging spending thereby triggering a virtuous cycle of development. This formula is great to initiate or prime the economy - but it is poor mechanism for transmission of wealth across income classes. Savings and host of economic factors ensure that the distribution of wealth so generated is lop-sided favouring the higher-income class.

The mistake
Most of the economies seems to have decided that answer to rising in-equality is in faster-higher-better priming. Partly, they cast their economies in the mould of market-share winning corporates. And like corporates these economies are intent on keeping "costs" down. The resultant "profits" were enormous and increasing. But there was a little difference with normal corporates. The employees of normal corporates interact back with the market. But employees of this nation-corporate only interact with themselves. (Either because of direct or indirect trade barrier like managed exchange rates) Therefore the higher profits could not be channeled into stake-holders - due to fear of inflation. So these had to be invested somewhere. So it is that this enormous forever-swelling pool of money found its way into US assets. Pushing the US consumer to carry this "little" extra burden. Then the unthinkable happened - US broke down - it was the last (Yuan) straw that broke the US back.

Where will Central banks find growth?
Now central banks are looking for growth. Now the same old principles wont apply. US consumer is not going to take any more burden. New consumers will have to be introduced into the system. China and India - these two countries who can inject tremendous amount of vitality into the system because of sheer numbers. But at current exchange rates both China and India are too small to carry the burden of US consumer.

Exchange rate correction will wipe out USD investment
As mentioned in yesterday's post, exchange rate revaluation will impact at least 2 trillion of China holdings. Opening the domestic market to world will further deplete this reserve. China will find itself in apparantly bad situation (first-order effect is pain). Fundamentally however this situation will better address the income discrepancy than its current policy - through third and fourth order effects. Yet can any country set aside the pain. I doubt - rather this will trigger a battle for consumer.

A confusing implication
Now there is a reverse implication of this. The "real" savings estimated in terms of purchaing power of future goods - will decline so long as exchange rate barriers dont break. This while savings are actually rising and inflation is low - and exchange rates are pegged. Anecdotally we can see amount of money required to maintain lifestyle is increasing faster than what inflation and wealth increase are telling us.

Key take-away
Exchange rate is key hurdle - from multiple sides - in addition to conventional fundamental reasons. There is going to be lot of pressure on Yuan at-least. Thats why my higher conviction on Yuan appreciation.

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Notes:
#) Some ideas half -developed - but important to highlight so posted half-baked.
#) James Fallow asked straight questions - I call them level 1 questions - we need to ask level 2 questions. E.g. relative pay-of to Chinese worker should be made in PPP terms or relative to China income distribution.
#) Just as I finished this I get this amazing article at Vox by Robert Dekle, Jonathan Eaton and Samuel Kortum. Will comment on it later.

China, US Dollar and making money in this situation!

Yves Smith is back to her best. She weaves together of thoughts on US situation, Chinese options and possible solutions at naked capitalism: Summers: "The global consensus on trade is unravelling". It raises many questions like Why is China buying US debt? And more generally Can you even think of making money in this situation? Here are my thoughts on the same.

China has limited options. A large part of its wealth is loaned to the US. Now the only volatile variable in this is exchange rate. If you have 2 trillion dollars sitting out there when exchange rate varies by 10% - I am sure you heart is in your mouth. If that much money has to retain value then it has to sit on something more robust than US debt!
For China, the only other way to retain value is to keep the relationship intact (because China CAN control one side of the peg!). But by committing to manage exchange rate - China now has no option but to be the large buyer of additional US debt. This is fine if China believes it can shore-up all the "remaining" US debt.
Now this situation is ripe for other nations, funds, entities to gradually off-load their USD holdings and retire to the peace of Euro, gold or some other value retainer. They are attracted by buying options for raw-materials i.e. food and energy. That makes the case for rising energy and food prices. This is same old logic behind this new-found attraction - hedging. Countries would ideally like to lock their costs in current prices to protect against future rise. So US debt problem now extends to US assets.

Where will China get the money to buy US assets?
While large part of the money comes from running trade surplus (for a little while), some part also comes through Chinese savings and investments. Chinese FDI is in a position to buy lot of US assets and given the situation - it will do so. Implication is if you have to shore up the Yuan for sometime and release it later - you will make a tidy dollar profit - if it is of any value.

So how do we retain - rather add value - sit on cash?
Sitting with cash (in local currency) is great stratgy for retaining value in local context. US domestic investors are ok with dollar profit - if they are going to spend it domestically. But most investors look to increase or at least preserve value. This was ok when dollar was default currency. It helped measure value - hence retain and enhance value. That was why nations bought US assets not because they were unusally attractive.
The other metric of value is the purchasing power. Lets say 10 dollars fetched one meal in 2008. Then all the current holdings should be measured in no. of meal terms. Then its easier to measure and enhance value again. So the best value retainers will be derieved from future consumption basket. So in-effect real hard-core hedging should help retain value. If smartly done - you may end up top of the heap.

Surely there is some hidden risk there too...
The situation becomes more critical if we realise that "contract enforcability" underlying the hedges can be threatened. This risk is sure to increase as money involved increases - i.e. when China realises it holds larger and larger share of US debt outstanding - and by that time China's stake would be probably greater than 4 trillion. Once China does realise - we are going to be in really, really tough times. In old times - this situation would be enough to cause a war. In today's times I hope not.

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Note: - The nakedcapitalism post is must read. It connects, complements and analyses this theme from Larry Summers FT article, Brad Setser (article I linked yesterday), William Greider, Dani Rodrik, Thomas Palley and El-Erian. I am fan of Yves Smith!
Also Steven Kamin has interesting findings at Vox.