Stephen Jen has a very interesting piece on currency appreciation and inflation. Normally, people would think appreciating currency would bring down import prices thus help to bring down inflation. In China’s case, rising Chinese Yuan (CNY) also discourages export, thus keeps fast rising current account surplus at bay, reducing the need for sterilization by central bank and slow down money supply growth in the domestic market. Both tend to ease inflation pressure eventually.

In his piece, Jen hypothesizes another possibility that rising expectations of future currency appreciation attracts large capital inflows (I think he meant hot money) thus dampens central bank’s hope that currency appreciation would reduce inflation pressure through the balance-of-payments channel.

One of the key structural forces of inflation in China, as is widely agreed, is the persistent and large rise in its official reserves, roughly half of which have, in recent years, been sterilised. What makes China’s case rather remarkable is that China not only runs a large C/A surplus (which averaged 7.4% of GDP during 2005-07), but it has also received very large capital inflows. Official reserves grew sharply from 2002 (US$286 billion) to 2005 (US$819 billion), but really accelerated in 2007 (reserves increased by US$461 billion). What is perhaps even more remarkable is that, while China’s C/A surplus has continued to expand, the growth (my emphasis) in net capital inflows in 2007 accounted for 59% of the total increase in reserves. To spell this out, China’s massive C/A surplus last year of US$206 billion accounted for ‘only’ 41% of the increase in official reserves. We argue that much of these large capital inflows may have been motivated by the general expectation that the CNY would continue to appreciate against the dollar at a rapid pace, and that having a short USD/CNY exposure was a high-yield zero-risk investment. Thus, rather perversely, while Beijing’s ultimate objective of bringing the value of the CNY more in line with the economic fundamentals should eventually lead to a more sustainable BoP position, the process of getting there is inflationary. In sum, while many have argued that the stronger CNY has helped China to contain inflation, we believe that precisely the opposite is the case.

Theoretically, the only way around this dilemma confronted by China is to have a maxi-revaluation in the CNY against the dollar of a size so large that few investors would believe that the CNY can appreciate further. This is the only effective way to halt the speculative capital inflows into China. The practical obstacle, however, is that it is not clear how big such a move in USD/CNY would have to be. Related to this question are the concepts of the ‘fair value’ and the ‘equilibrium value’ of USD/CNY. The former is the value of USD/CNY that is consistent with the underlying economic fundamentals (e.g., productivity, terms of trade, etc.), while the latter is the value of USD/CNY that will help to close China’s BoP surplus. We believe that the current spot USD/CNY is already close to the ‘fair value’. However, to close China’s BoP surplus, USD/CNY would probably need to decline by a massive (50%?) amount. Would Beijing feel comfortable implementing a step revaluation in CNY from 7.00 to 3.50 in one go? We doubt it.

Look at below graph first (h/t to wsj article, “You Can’t Soak the Rich“):

I am amazed by the fact that no matter what tax rates are, tax revenue always remains at around 19.5% of GDP (post WWII). Laffer curve would help to explain this mysterious finding: when government increases tax rate, it’s supposed to discourage incentives to work and invest, so GDP shrinks; when government lowers tax rate, the opposite is true and GDP increases. So on average, tax revenue as % of GDP may be quite stable, but I did not expect it’s a fixed number. The 19.5% number is amazing to me.

read the full article here

Central bankers talk about inflation more than a teenage boy thinks about sex. Perhaps they talk about it too much. In contrast to teenage boys, for whom less action would probably be a good thing, central banks would be well advised to talk less and act more. In the US, the Euro Area and the UK, the track record of inflation during the past few years has deteriorated to the point that a material loss of credibility may well be imminent for all three central banks involved – the Fed, the ECB and the Bank of England.

more here…

The US stock market had a nice rally since mid March. Dow has surged almost 11%. Yet, we are in recession and problems in the in the financial sector are far from over and the outlook for both consumer spending and employment is quite murky, if not perssimistic. WSJ asks the question, “Is the rally for real?

Related, market volatility as measured by VIX has been dropping sharply. Are we going to see the volatility bounce back again some time soon? Just to repeat the previous 3 (or 4) rounds? (see the graph below).