The Conundrum that is China

By: Paul_Petillo

There are currently two undeniable truths in this new global marketplace: The US will buy what it wants with borrowed money and the Chinese have so far enabled that buying spree by loaning us the cash.

China has become an economic enigma. Growth in the country is running over 11% and inflation, now at 3.3%, slightly over what China considers reasonable, is beginning to increase much to the dismay of the Communist government.

Concerns over what can be done have left many investors wondering what Chinese officials will do. Investors who believe that an economy needs to grow but disagree on how much growth this good worry that any shifts in Chinese economic policy will ripple around the world. Investors in China sent their exchange tumbling over 4% recently when the government targeted borrowing excesses.

Bad Posture

The United States left with fewer options as its own economic growth slows, has chosen our trade deficit with China as the line in the sand. With dissatisfaction expressed as strongly as they dare, the Department of Commerce decided that imported “coated free” paper was as good a place to begin a revised stance.

This paper product generates slightly more that $224 million in sales here in the US . Hoping that this would allow manufacturing in this country the opportunity to begin to chisel away at the $763.6 billion deficit, the DOC chose this industry suggesting that Chinese government subsidies allow exporters to sell the paper well below costs.

The DOC is focusing solely on unprinted materials and to put that item in better perspective, it makes up only 0.0002% of that total trade deficit.

The US has threatened to use countervailing duties. Described by the World Trade Organization as the result of an investigation that accuses a country of subsidizing an industry to keep competition at bay, this action creates several problems for China .

China would like to achieve a growth rate close to 8%. Yet government officials worry that the state of social stability hangs in the balance should growth slow significantly. The cascading effect of slow growth would increase the value of Yuan, which would increase the value of imported goods while making those cherished exports more competitively priced.

Yet by comparison, we seem equally as vulnerable. With our most willing lender using strongly worded rebuttals such as “deep regret”, the enthusiasm of U.S. Commerce Secretary Carlos Gutierrez over this US action should be somewhat tempered. It is widely predicted that the US will be dealing with a slowdown of its own over the next two years and in no position to cry foul.

Fair Trade

This week, the Canton Import and Export Fair opened in Canton . As businesses from around China gather to this yearly event to display their wares to foreign buyers, they seem little concerned about the trade stance the US is making.

Barriers to trade have been tumbling worldwide creating new markets for Chinese goods. Prosperity in developing countries and largely unrestricted trade policies across Europe (except when it comes to shoes) has given the attendees at the fair the ability to predict expanded growth in exports to continue.

While the US deficit has grown to record levels, exports to this country have fallen steadily from the 2000 high of 31%. Six years later, that number is now 22.7% as China expands its list of customers beyond the American consumer.

Perhaps a better representation of just how far apart these two nations are when it comes to exports lies in the output numbers. China exports 10% of its output to the US . We export 0.2% of our products to China .

The Orderly Fall of the Dollar

As hard as he has tried, Treasury Secretary Henry Paulson has failed at every attempt to get the Chinese to allow their currency to float. The importance of the Yuan, which has appreciated against the dollar a total of 7%, has had little impact in these trade issues. A strengthening Euro has made Chinese exports, which have become cheaper as that currency has risen, has given the Chinese a new and freer market.

Less than five years ago, the specter of a declining US economy would have given the Chinese a reason for caution. No more. The European economy seems to be adjusting to the US slowdown even as it contemplates another interest rate increase.

Inflation on a global scale may be inevitable. While Ben Bernanke, the Federal Reserve Chief has suggested that inflation will be fought with his favorite counterbalance, rate increases, it may now require an international effort. That will become an increasingly difficult sell to countries that have never experienced this type of prosperity.

The Hand the Feeds

The one fact remains, China loans us the capital we use to keep our economy humming. Harder language could jeopardize any future growth here at home while having little effect on our lender of choice.

China has been responsible for purchasing a third of the bonds issued by the government. There has been speculation that a sudden dissatisfaction with US trade policies could trigger a sell-off of the $990 billion in bonds currently held by the Chinese. While it is possible, it is also unlikely.

What is likely although may be just as problematic. Should the Chinese stop buying Treasury bonds, rates here in the US would increase dramatically which would have the cascading effect of slowing the economy and dampening the desire for Chinese imports. The US is betting against such risks.

Internally, China has attempted to slow its economy by restricting loans that are not government approved. A recent edict aimed at local government spending for building has emphasized a return to the austere suggesting any future projects be “stately, frugal, functional, and resource-efficient”.

Increases in the reserve limits that Chinese banks must have before lending will also slow growth. Allowing the Yuan to appreciate would have the net effect of slowing the growth rate of the Chinese economy. But the fix would only be temporary.

The US would do well to tread cautiously while heeding an old Chinese curse that suggests: “May you live in interesting times”.

By Paul Petillo
Managing Editor
http://bluecollardollar.com

Paul Petillo is the Managing Editor of the http://bluecollardollar.com and the author of several books on personal finance including "Building Wealth in a Paycheck-to-Paycheck World" (McGraw-Hill 2004) and "Investing for the Utterly Confused (McGraw-Hill 2007). He can be reached for comment via: editor@bluecollardollar.com

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