This is a story that happened in a small village. About 200 families made it their home. There was a rich man in that village. The rich man was the head of the village also. And there was a hard working but poor merchant there.
Our story begins long back, when the grandfather of the Merchant decided that he has to break some rules. The Merchant was poor because he was in the habit of trading with the people he knew well. He did not sell his merchandise to any body else other than, selected few people of his community. Grandfather decided that it would be better for his family, if he began trading with the Rich Man. Grand father was very respected in the household and hence there was no opposition to what he said. The family was strict and respected its elders. Merchant met the Rich Man for the first time after many years and expressed his wish to sell his merchandise to him. Rich Man agreed because the Merchant had very good wares and sold it for a small profit only. Rich Man was very happy.
Their dealings started and both were happy. There were other traders in the village as well. Some of them like Albert, Louis and his friends were not happy that Rich Man was buying his needs from the Merchant. So they convinced the Rich Man, that he should not buy his entire requirement from the Merchant, and he is obligated to buy the merchandise of Louis, Albert and his friends. Rich Man agreed to that, even though the prices of these groups of people were much higher than the Merchant. It was a good policy for the Rich Man, because the Grand father had just died, and his sons were unpredictable. Rich Man did not want to depend on Merchant for everything; he wanted his supplies to be met properly. In return for his favor, Rich Man took the same promises from Louis, Albert and friends.
The poor merchant protested against this arrangement of Rich Man. He said that he had a big family, and he will remain poor if the Rich Man did not buy his goods. Rich Man convinced the poor Merchant after some time, he will buy all the necessities from Merchant, if he can sell cheaper than others. Poor Merchant having no other choice, agreed.
As the time progressed, the trade between the Rich Man and the Poor Merchant grew. They were small because of the Rich Man's agreement. But it was a big improvement in their relationships.
At first the Poor Merchant gave cheap and best prices to the Rich Man, which he bought against the cash. As the trade between them grew, the Rich Man was not able to pay the full amounts and the Poor Merchant also agreed to carry some credit. The trade grew and knew no bounds.
The Poor Merchant faced the first economic paradox. As the trade grew, Merchant became Rich. But if he became Rich, we would not be able to sell the merchandise at low prices like he was doing. So, the paradox was, he had to stay poor so that he can become rich. This is how the paradox worked. As the Merchant became rich, his reputation and credibility in the market will increase. Because of this his value in the market will increase in the market and there will be lot of people willing to trade with him. If he traded more with them, and because he was a good trader, the value was bound to increase more. Finally there will be a stage where no body would be able to afford his merchandise and he will become poorer!
Now the primary concern for the Merchant was that his value should not increase more than the Rich Man. That was because, if his value increased a lot more than the Rich Man, Merchant would not be able to sell the goods at low prices as he was selling. Since the Rich Man bought most amounts of goods, if the Rich Man did not buy them, the Merchant would naturally be poor again.
Nobody wants to be poor not even the Merchant. So he decided to follow the clever middle path strategy. He decided that he will trade with anybody who is willing to trade with him, whether it is Albert, Louis, Steve or others. But he will see to it that he will be able to sell to the Rich Man at same prices. How was he going to do that? This way. Now suppose that Rich Man buys a table from merchant presently he pays 100 gold coins to the Merchant. Now with increased trading with others, when the value of the same table is bid up by the Louis or Steve to 125 gold coins, it is not wise for the Merchant to sell the same table to Rich Man at 100 gold coins. The clever way he thought out was, sell the table to the Rich Man at 125 gold coins and lend the Rich Man back his extra 25 gold coins for a very low rate of interest.
This scheme was very good for the Rich Man because he could buy 125 Gold coins worth of produce and yet pay only 100 gold coins. This will help him to maintain his consumption at very low prices and he will be able to consume more. For the Merchant, it allowed him to trade with other people as he chose fit and increase his value, but yet not loose his prime customer the Rich Man.
This scheme of things progressed well. The produce of the Merchant was very good and they were snapped up by the Rich Man in large quantities, because they were cheaper than others and were of better quality.
Rich Man grew richer by the day, because he was buying the goods cheaper. So he had a lot of money left over to buy other things from others. Rich Man bought many other things from Steve, Louis etc. The Rich Man was truly happy and his household flourished.
Rich Man conveniently forgot about the credit the poor merchant was giving him. He was too happy. Until finally he realized the debt he owed to poor merchant was Huge. Rich Man was now hopelessly dependent on the Merchant to maintain and grow his standard of living. Even the Merchant was beginning to realize that he was giving too much credit to the Rich Man indirectly. He was worried because he also realized that Rich Man had taken too much debt. Moreover there was lot of opposition from the Merchant's sons that a lot of money was given as a debt to the Rich Man at a very low interest rates and helping the Rich Man enjoy the luxuries. The Merchant though became richer by many folds, was still poor as his family was a big family. The sons were correct in saying that there was lot of expenses in the house itself, which had to be met first. As mentioned earlier the household, was a strict place, and nobody complained severely.
Not only Merchant, but also others in the village like Louis, Albert and others knew the debt position of the Rich Man. Some people like Albert almost entirely stopped trading with the Rich Man or charged a higher premium for his produce. Rich Man was finally feeling the pressure of the debt he had built up. He decided to ask the Merchant to reduce the value of the goods he had bought, a kind of bargaining. The only difference this time was it was bargaining for the goods Rich Man had used for years. The Merchant was perplexed; he was confused and obviously resisted any move by the Rich Man to reduce its value. Remember, the prices offered by the Merchant were already low. And if the Rich Man's argument was to be taken, then the entire history will be re-written. This is how it works.
Rich Man had bought the table from the Merchant several years ago for 125 gold coins. The Merchant gave back 25 gold coins to Rich Man at very low interest rates. Now, if the bargain of Rich Man was taken, there are two ways of doing it. For example if the Rich Man is asking for 5 gold coins lower, the table will be worth 95 gold coins. This will hit the profits of the Merchant. This was not much of a problem as the trade was already completed.
But the real problem was the Rich Man was asking Merchant to lower the value of debt given. Therefore of the 25 gold coins that Merchant had given the Rich Man, only 20 Gold coins will be returned!
There was a huge debate in the Merchants house of how to do this. There was no question of challenging the Rich Man, as he still was the Richest Man in the village, though had taken a huge debt. The debate was not even about the Merchant whether he should have given the part of the money back, at that point in time, Merchant needed somebody to buy many things he produced and the Rich Man was a logical choice. The debate was weather the Merchant should have overlooked his own family for the trade reasons. Now the Rich Man wanted a discount for the things he had consumed. The same produce the Merchant could have sold it to others at higher price. Made a lot more profit. Merchant also gave back a major portion of the profits back to the Rich Man as loans at very less interest rates. The money which Rich Man used to consume more luxurious items. The money that Merchant will loose if he accepts Rich Man's proposals could have been gainfully used for the benefit of the family. Now it would so seem, the Merchant and his family worked hard so that the Rich Man could consume luxurious items. Now by giving discounts to Rich Man, out of their savings [profits] the family has to pay so that the Rich Man and his family could enjoy. This is a classic case of make the cake, let Rich Man eat it and pay his bill too!
The debate was silent, it was a strict household.
The smart strategy of the Merchant didn't look that smart now. But looking at the trade consideration it was a good strategy. But strategy itself began to loose value after a certain point in time. The Law of Diminishing effect.
In the real world the Rich Man is USA and the Merchant is China. The trade between US and China got the real impetus in late 1970's when Deng Xio Pang liberalized the economy. The trade was good for the 80's. But in the beginning the Early 90's China was beginning to accumulate the US treasury bills. This accumulation was very much legitimate at first. US is one of the richest countries and it is a good policy to invest its proceeds into the good asset which in this case was US treasuries. This was legitimate and advisable.
Chinese were facing problems with the export competitiveness in the mid 90's as the competition form Malaysia, Philippines etc increased. It was then, they accidentally fell into the trap of pegging of their currency. By pegging, you do not allow the Dollar-Yuan [Chinese currency] to move. So no matter what the amount of trade, the value of the Merchant remains the same. But this was still not a policy, it is just something that they happened to do. The South-east Asia crisis in 1997, when there was a large scale outflow of the foreign investors from this region began to hurt, was the point where this pegging was made a policy. From then on till now, the Yuan has been pegged at one rate. 8.28Yuan for a dollar.
How can a country keep its currency pegged? Simply put, by not allowing the currency not to go down or go above a fixed level in the base currency. This is how it works.
Trade involves two things, inflows of money and outflows of money. When one currency is more in demand than the other currency of the trading nations, the fluctuations happen. The US-China trade, has almost been one sided, with China receiving money and US giving money. The inflows into a country can happen because of two reasons. One is, when the US importer pays Chinese exporter with Yuan. The other way money comes into China, is when the US companies open their factories, offices and other investments in China. The dollar is of no use in China, whose official currency is Yuan. Therefore, ultimately all the inflows are converted into Yuan either by the exporter or the multinational that is opening the offices in China. Since, the China has been exporting huge amounts of goods to US and the foreign multinationals have been investing in China heavily, the demand for Yuan [for the conversion reasons] is very high. Naturally, since the demand is high, the Yuan's value will go up.
But if the value of Yuan goes up, the exports of China becomes costlier for the US citizens.
This is how it works. For example, if a Chinese exported shoe costs 80 Yuan in China and if the exchange rate was 8 Yuan per dollar; the US citizen will pay $8 [80Y / $8] for a pair of shoe. Now, with increased trade, if the exchange rate goes up to 5 Yuan per dollar, the US customer will have to pay $16 [80Y / $5] for a pair of shoe. So, naturally the demand for this product goes down. That is simple economics.
China faced the same problem highlighted in the Story above. If it exports more to US, and if the US MNC's invest more in China, the demand for Yuan will be up and export will be hurt. Why will MNC invest in a country from where it cannot export? So the country as such, will be worse off. To peg the China had to create an equal and opposite force to the Yuan demand. That is, they had to create a demand for the Dollar. Whenever the Yuan faced lot of pressure for appreciation, the Chinese government created an equal pressure on Dollar and therefore their values dint change. Thus the Yuan was pegged.
For the dollar demand to be created, Chinese government was routinely buying dollars from the MNC's and the exporters. Dollar, is just a currency and is of no use by itself. Therefore the Chinese government used these dollars to buy the US government bond [US treasury bills]. Buying was good because, it gives them some interest rates, even though it was very low. And thus the accumulation began. Government bonds are the means by which government borrows money from financial markets. Thus started the vicious cycle of funding the US government.
And what was the effect of Rich Man's bargain on China.
Beginning from early 90's China had accumulated nearly $500bn of US treasury bills. The bills whose real interest rates [interest rates after adjusting to inflation] were in the region of 0.75-1.5%. $500bn that could have been invested in the country health, education, illiteracy, infrastructure, housing etc, was blocked in US treasuries. US was having a party with Chinese money while the Chinese themselves were dying of starvation and disease.
A few days back the Chinese government agreed to remove its pegging to dollar. This was done on "international pressure". International pressure = Rich Man's pressure. They revalued it by about 2%. In other words, 2% of $500bn - $10bn gone up in smoke. Rs 45,000Crores. Just like that. The money that could have been used for the Social welfare for the poor Chinese citizens - gone. The market expects Yuan to go up by about 10% in a year’s time. Put that in numbers, $50bn is going to go up in smoke, in a year’s time.
And $50bn is a huge sum of money. India's entire planned infrastructure expenditure for the next 20 years is just $30bn. US had a party right through the 90's and all these years. A booming stock market, a booming IT industry, a booming housing sector etc. The bill is to be paid by the poor Chinese who works 12-14 hours a day, to make enough sum of money the US citizens spend on dog food.
This is the story of the Rich Man and the Poor Merchant.
Our story begins long back, when the grandfather of the Merchant decided that he has to break some rules. The Merchant was poor because he was in the habit of trading with the people he knew well. He did not sell his merchandise to any body else other than, selected few people of his community. Grandfather decided that it would be better for his family, if he began trading with the Rich Man. Grand father was very respected in the household and hence there was no opposition to what he said. The family was strict and respected its elders. Merchant met the Rich Man for the first time after many years and expressed his wish to sell his merchandise to him. Rich Man agreed because the Merchant had very good wares and sold it for a small profit only. Rich Man was very happy.
Their dealings started and both were happy. There were other traders in the village as well. Some of them like Albert, Louis and his friends were not happy that Rich Man was buying his needs from the Merchant. So they convinced the Rich Man, that he should not buy his entire requirement from the Merchant, and he is obligated to buy the merchandise of Louis, Albert and his friends. Rich Man agreed to that, even though the prices of these groups of people were much higher than the Merchant. It was a good policy for the Rich Man, because the Grand father had just died, and his sons were unpredictable. Rich Man did not want to depend on Merchant for everything; he wanted his supplies to be met properly. In return for his favor, Rich Man took the same promises from Louis, Albert and friends.
The poor merchant protested against this arrangement of Rich Man. He said that he had a big family, and he will remain poor if the Rich Man did not buy his goods. Rich Man convinced the poor Merchant after some time, he will buy all the necessities from Merchant, if he can sell cheaper than others. Poor Merchant having no other choice, agreed.
As the time progressed, the trade between the Rich Man and the Poor Merchant grew. They were small because of the Rich Man's agreement. But it was a big improvement in their relationships.
At first the Poor Merchant gave cheap and best prices to the Rich Man, which he bought against the cash. As the trade between them grew, the Rich Man was not able to pay the full amounts and the Poor Merchant also agreed to carry some credit. The trade grew and knew no bounds.
The Poor Merchant faced the first economic paradox. As the trade grew, Merchant became Rich. But if he became Rich, we would not be able to sell the merchandise at low prices like he was doing. So, the paradox was, he had to stay poor so that he can become rich. This is how the paradox worked. As the Merchant became rich, his reputation and credibility in the market will increase. Because of this his value in the market will increase in the market and there will be lot of people willing to trade with him. If he traded more with them, and because he was a good trader, the value was bound to increase more. Finally there will be a stage where no body would be able to afford his merchandise and he will become poorer!
Now the primary concern for the Merchant was that his value should not increase more than the Rich Man. That was because, if his value increased a lot more than the Rich Man, Merchant would not be able to sell the goods at low prices as he was selling. Since the Rich Man bought most amounts of goods, if the Rich Man did not buy them, the Merchant would naturally be poor again.
Nobody wants to be poor not even the Merchant. So he decided to follow the clever middle path strategy. He decided that he will trade with anybody who is willing to trade with him, whether it is Albert, Louis, Steve or others. But he will see to it that he will be able to sell to the Rich Man at same prices. How was he going to do that? This way. Now suppose that Rich Man buys a table from merchant presently he pays 100 gold coins to the Merchant. Now with increased trading with others, when the value of the same table is bid up by the Louis or Steve to 125 gold coins, it is not wise for the Merchant to sell the same table to Rich Man at 100 gold coins. The clever way he thought out was, sell the table to the Rich Man at 125 gold coins and lend the Rich Man back his extra 25 gold coins for a very low rate of interest.
This scheme was very good for the Rich Man because he could buy 125 Gold coins worth of produce and yet pay only 100 gold coins. This will help him to maintain his consumption at very low prices and he will be able to consume more. For the Merchant, it allowed him to trade with other people as he chose fit and increase his value, but yet not loose his prime customer the Rich Man.
This scheme of things progressed well. The produce of the Merchant was very good and they were snapped up by the Rich Man in large quantities, because they were cheaper than others and were of better quality.
Rich Man grew richer by the day, because he was buying the goods cheaper. So he had a lot of money left over to buy other things from others. Rich Man bought many other things from Steve, Louis etc. The Rich Man was truly happy and his household flourished.
Rich Man conveniently forgot about the credit the poor merchant was giving him. He was too happy. Until finally he realized the debt he owed to poor merchant was Huge. Rich Man was now hopelessly dependent on the Merchant to maintain and grow his standard of living. Even the Merchant was beginning to realize that he was giving too much credit to the Rich Man indirectly. He was worried because he also realized that Rich Man had taken too much debt. Moreover there was lot of opposition from the Merchant's sons that a lot of money was given as a debt to the Rich Man at a very low interest rates and helping the Rich Man enjoy the luxuries. The Merchant though became richer by many folds, was still poor as his family was a big family. The sons were correct in saying that there was lot of expenses in the house itself, which had to be met first. As mentioned earlier the household, was a strict place, and nobody complained severely.
Not only Merchant, but also others in the village like Louis, Albert and others knew the debt position of the Rich Man. Some people like Albert almost entirely stopped trading with the Rich Man or charged a higher premium for his produce. Rich Man was finally feeling the pressure of the debt he had built up. He decided to ask the Merchant to reduce the value of the goods he had bought, a kind of bargaining. The only difference this time was it was bargaining for the goods Rich Man had used for years. The Merchant was perplexed; he was confused and obviously resisted any move by the Rich Man to reduce its value. Remember, the prices offered by the Merchant were already low. And if the Rich Man's argument was to be taken, then the entire history will be re-written. This is how it works.
Rich Man had bought the table from the Merchant several years ago for 125 gold coins. The Merchant gave back 25 gold coins to Rich Man at very low interest rates. Now, if the bargain of Rich Man was taken, there are two ways of doing it. For example if the Rich Man is asking for 5 gold coins lower, the table will be worth 95 gold coins. This will hit the profits of the Merchant. This was not much of a problem as the trade was already completed.
But the real problem was the Rich Man was asking Merchant to lower the value of debt given. Therefore of the 25 gold coins that Merchant had given the Rich Man, only 20 Gold coins will be returned!
There was a huge debate in the Merchants house of how to do this. There was no question of challenging the Rich Man, as he still was the Richest Man in the village, though had taken a huge debt. The debate was not even about the Merchant whether he should have given the part of the money back, at that point in time, Merchant needed somebody to buy many things he produced and the Rich Man was a logical choice. The debate was weather the Merchant should have overlooked his own family for the trade reasons. Now the Rich Man wanted a discount for the things he had consumed. The same produce the Merchant could have sold it to others at higher price. Made a lot more profit. Merchant also gave back a major portion of the profits back to the Rich Man as loans at very less interest rates. The money which Rich Man used to consume more luxurious items. The money that Merchant will loose if he accepts Rich Man's proposals could have been gainfully used for the benefit of the family. Now it would so seem, the Merchant and his family worked hard so that the Rich Man could consume luxurious items. Now by giving discounts to Rich Man, out of their savings [profits] the family has to pay so that the Rich Man and his family could enjoy. This is a classic case of make the cake, let Rich Man eat it and pay his bill too!
The debate was silent, it was a strict household.
The smart strategy of the Merchant didn't look that smart now. But looking at the trade consideration it was a good strategy. But strategy itself began to loose value after a certain point in time. The Law of Diminishing effect.
In the real world the Rich Man is USA and the Merchant is China. The trade between US and China got the real impetus in late 1970's when Deng Xio Pang liberalized the economy. The trade was good for the 80's. But in the beginning the Early 90's China was beginning to accumulate the US treasury bills. This accumulation was very much legitimate at first. US is one of the richest countries and it is a good policy to invest its proceeds into the good asset which in this case was US treasuries. This was legitimate and advisable.
Chinese were facing problems with the export competitiveness in the mid 90's as the competition form Malaysia, Philippines etc increased. It was then, they accidentally fell into the trap of pegging of their currency. By pegging, you do not allow the Dollar-Yuan [Chinese currency] to move. So no matter what the amount of trade, the value of the Merchant remains the same. But this was still not a policy, it is just something that they happened to do. The South-east Asia crisis in 1997, when there was a large scale outflow of the foreign investors from this region began to hurt, was the point where this pegging was made a policy. From then on till now, the Yuan has been pegged at one rate. 8.28Yuan for a dollar.
How can a country keep its currency pegged? Simply put, by not allowing the currency not to go down or go above a fixed level in the base currency. This is how it works.
Trade involves two things, inflows of money and outflows of money. When one currency is more in demand than the other currency of the trading nations, the fluctuations happen. The US-China trade, has almost been one sided, with China receiving money and US giving money. The inflows into a country can happen because of two reasons. One is, when the US importer pays Chinese exporter with Yuan. The other way money comes into China, is when the US companies open their factories, offices and other investments in China. The dollar is of no use in China, whose official currency is Yuan. Therefore, ultimately all the inflows are converted into Yuan either by the exporter or the multinational that is opening the offices in China. Since, the China has been exporting huge amounts of goods to US and the foreign multinationals have been investing in China heavily, the demand for Yuan [for the conversion reasons] is very high. Naturally, since the demand is high, the Yuan's value will go up.
But if the value of Yuan goes up, the exports of China becomes costlier for the US citizens.
This is how it works. For example, if a Chinese exported shoe costs 80 Yuan in China and if the exchange rate was 8 Yuan per dollar; the US citizen will pay $8 [80Y / $8] for a pair of shoe. Now, with increased trade, if the exchange rate goes up to 5 Yuan per dollar, the US customer will have to pay $16 [80Y / $5] for a pair of shoe. So, naturally the demand for this product goes down. That is simple economics.
China faced the same problem highlighted in the Story above. If it exports more to US, and if the US MNC's invest more in China, the demand for Yuan will be up and export will be hurt. Why will MNC invest in a country from where it cannot export? So the country as such, will be worse off. To peg the China had to create an equal and opposite force to the Yuan demand. That is, they had to create a demand for the Dollar. Whenever the Yuan faced lot of pressure for appreciation, the Chinese government created an equal pressure on Dollar and therefore their values dint change. Thus the Yuan was pegged.
For the dollar demand to be created, Chinese government was routinely buying dollars from the MNC's and the exporters. Dollar, is just a currency and is of no use by itself. Therefore the Chinese government used these dollars to buy the US government bond [US treasury bills]. Buying was good because, it gives them some interest rates, even though it was very low. And thus the accumulation began. Government bonds are the means by which government borrows money from financial markets. Thus started the vicious cycle of funding the US government.
And what was the effect of Rich Man's bargain on China.
Beginning from early 90's China had accumulated nearly $500bn of US treasury bills. The bills whose real interest rates [interest rates after adjusting to inflation] were in the region of 0.75-1.5%. $500bn that could have been invested in the country health, education, illiteracy, infrastructure, housing etc, was blocked in US treasuries. US was having a party with Chinese money while the Chinese themselves were dying of starvation and disease.
A few days back the Chinese government agreed to remove its pegging to dollar. This was done on "international pressure". International pressure = Rich Man's pressure. They revalued it by about 2%. In other words, 2% of $500bn - $10bn gone up in smoke. Rs 45,000Crores. Just like that. The money that could have been used for the Social welfare for the poor Chinese citizens - gone. The market expects Yuan to go up by about 10% in a year’s time. Put that in numbers, $50bn is going to go up in smoke, in a year’s time.
And $50bn is a huge sum of money. India's entire planned infrastructure expenditure for the next 20 years is just $30bn. US had a party right through the 90's and all these years. A booming stock market, a booming IT industry, a booming housing sector etc. The bill is to be paid by the poor Chinese who works 12-14 hours a day, to make enough sum of money the US citizens spend on dog food.
This is the story of the Rich Man and the Poor Merchant.
:) Falkor
Note : This article was written sometime in August, the Chinese yuan has not appreciated much since writing.
First published http://surff.blogspot.com/2005/11/rich-mans-story-part-i.html
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