China likely to weaken dollar faster despite risks, Dumas says

China will have to further relax the renminbi’s peg to the dollar to avoid rampant inflation and interest rises, according to the chairman of Lombard Street Research (LSR), despite the risks to dollar-denominated debt.

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Charles Dumas observes China’s consumer price index inflation has increased 5.4 percentage points in just four months, from a contraction of 1.8% at its low point in July 2009 to 3.6% in August.

Although China has just raised interest rates to help cope with the problem, Dumas describes the inflation increases as “a huge shift in what is becoming the wrong direction”.

Dumas has already warned investors to expect volatility in China next year, exacerbated by the proposed second round of quantitative easing. (article continues below)

Appreciating the renminbi against the dollar would give it more buying power and hence help contain inflation. It would also help prevent consumers stashing away even more money to ensure the size of their savings keeps pace with inflation.

However, as a result of relaxing the currency peg further China would have to sell fewer renminbi and buy fewer  dollars or even dollar-denominated assets, such as American government bonds.

As its export sector would weaken as a result of the currency strengthening, it may also have to inject stimulus money into the economy from its reserves, a large part of which are also held in American federal debt.

As Bart Turtelboom and Karim Abdel-Motaal, the co-heads of emerging markets at GLG Partners, have pointed out, this risks a vicious spiral, which caused the currency peg to be retained in the first place.

They observe a weakening dollar and strengthening emerging market currencies make it impractical for emerging markets to refinance their enormous reserves of dollar-denominated treasuries.

The question is especially pertinent at present given the ultra-low yields on American treasuries, which are currently insufficient to make up for rising inflation in China.