China Is Stuck Between A Rock And A Hard Place

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What's going on?

On Monday, the Chinese government said to banks in China: you can lend more money. It sounds so simple, but it speaks to the very heart of the challenge China is currently facing: how to promote economic growth while keeping its currency from collapsing in value.

What does this mean?

All banks have to keep some of their money in cash so that if, for example, you want to take money out of your account, it is there for you to take. The Chinese regulator has now reduced the minimum amount that banks must keep in cash. So, banks can now lend more money to people and companies that will, in theory, buy and build things and, in turn, stimulate the economy.

Consequently, China increased the supply of money in its economy: instead of banks keeping it tucked away, they are now lending it out. And the value of money is determined, as most things are, by supply and demand (e.g. when there is more supply of something, it is worth less). So now the Chinese currency, the yuan, should be worth less.

Why should I care?

The bigger picture: The risk of China’s currency falling sharply in value is increasing. China’s economy appears to still be slowing. That means people have less demand for money (e.g. entrepreneurs are less likely to start a business if the economy is slowing). And yet, in the past year, China has hugely increased the amount of money available in its economy. That should have caused the currency to decline in value significantly but the Chinese government has been directly buying the yuan because it doesn’t want it to fall too quickly (see our previous article for a deeper explanation). It can’t afford to do this forever.

For markets: A sharp decline in the value of China’s currency could be very bad for global markets. A ton of global demand has come from China in the past 10 years: not just from buying commodities but also all of the Apple phones and Starbucks that are sold within China (amongst many other things). Imagine everything they import into China gets 30% more expensive for them – that would seriously hurt their demand for things and significantly hurt the intertwined global economy. And that would, almost certainly, be bad for stocks globally.

Originally posted as part of the Finimize daily email.

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