HOT MONEY

Anticipating a revaluation, speculators are sending hordes of money to China. The other financial bubble: China and the RMB. How do they maintain the currency peg in light of the increasing demand?

Here's how sterilization works: Chinese companies that earn export earnings in dollars and other foreign currencies usually have their banks exchange them for yuan. A company with $100 million in export earnings could wind up with some 800 million yuan in its bank account. Foreign investors also ship dollars into China by the truckload to spend on new plants and securities. This money is converted into yuan deposits, too, giving China's banks huge wads of yuan to lend. In the past the banks had a bad habit of recklessly lending this money for construction of steel plants and other industrial enterprises. To keep a lid on such lending, the PBOC has been selling short-term bills to the banks, taking excess yuan out of circulation.

Right now the cost of neutralizing the flows is low. The PBOC can sell its short-term central bank bills to Chinese banks for 1.5% and reinvest that cash in longer-range domestic and foreign bonds at higher returns. Yet if the government bumps up interest rates to cool China's economy, this mopping-up process could get expensive, driving up the already sizable liabilities of the Chinese government. The other risk is that China's foreign exchange stockpile -- already equal to about 40% of gross domestic product and parked mostly in U.S. Treasuries -- could face a valuation hit if the yuan appreciates. "The more accumulated [reserves], the greater the losses," says Frank F.X. Gong, chief China economist at JPMorgan Chase & Co. (JPM ) in Hong Kong.

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BILL GROSS ON THE DOLLAR (KIND OF)

Bill Gross of PIMCO, based out of, ahem, Newport Beach, on Treasuries, inflation and the world's reserve currency. Quote:

They say never sell America short and with good reason. Any country whose equity market has been able to crank out 6.8% real returns annually over the past century stands as a formidable obstacle for any speculator willing to bet the "don't come" line. The odds of winning a long-term wager laid against the U.S. "house" have been about as bad as heading out to the track and betting on your favorite color of jockey silks. Even when the bear gets his facts right, the timing and the wait often spell his doom; the "house" has more chips, especially a house with reserve currency status like the U.S., so a wager must be done prudently in order to conserve capital for that prospective rainy day.

The Gross forecast on the U.S. economy:

Our point on the "Pump" then, is to suggest that in combination with a globalized free trade-based economy exhibiting a surfeit of cheap Asian labor, it will be difficult to generate U.S. inflation higher than our current 3% even if interest rates fall further. If 3% inflation is all we can get from the past 5-years' asset inflation, it's hard to believe that we get more from what's left. The potential to reflate via interest rates is nearly over. We draw the same conclusion for Euroland and Japan. Japan, of course, is the primary example of how 0% nominal yields can fail to generate any inflation whatsoever, is it not? Continued disinflation not reflation, then, will rule our fragile future kingdom, with the potential for 1-2% CPI prints in most years between 2006 and 2010 throughout much of the global economy. Readers may remember our past few years' Secular Forum descriptions of the tug-of-war between disinflation and reflationary forces. We have proclaimed a winner based on our observation of massive fiscal and monetary global stimulation described above, the limited inflationary response, and the lack of further ammunition. Long live our disinflationary King.

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