Will the Chinese Pull the Plug?
A blog entry by Roubini about the upcoming collapse of the US economy has caught a lot of attention—being translated into Chinese and discussed on the Financial Times as well (see America’s economy risks mother of all meltdowns). The blog listed 12 steps leading to the collapse the US economy. They are, more or less, related to the credit market and housing market collapse. Some of those steps have already taken place, while others are in danger to materialize. The consequence of all these fallouts, if taking place as predicted, will be quite damaging to the US economy and other countries as well. But I think we are missing another critical point. That is, what if the Chinese are unwilling to support the US trade deficit? What if the Chinese start to scale down their purchase of US Treasures (debt)?
This question has been asked by many people and the answer used to be that the Chinese cannot afford to stop buying the US bonds issued by Treasury. It was correct. To keep Chinese currency, Yuan, artificially low, the Chinese Central Bank has to keep buying dollars and park those dollars in the US bond market for a safe, but rather low return. And that is why the Chinese accumulated so much US dollars ($1.5trillion as of late, more than China’s total GDP in 2007).
However, things are changing. The Chinese are now facing severe inflation due to oversupply of Chinese Yuan. To combat against inflation, people start to consider a faster revaluation of Yuan. That is the policy that was considered to be disastrous to China’s export sectors, which in the past years drove China’s growth engine and have been a critical employment source.
But most recently, willingly or unwillingly, the Chinese authority started to accelerate Yuan’s appreciation pace, and at the current rate, it would probably appreciate about 18%-20% against the US dollar by the end of 2008, much faster than the appreciation rate in 2007. This would probably kill exports, especially those low margin, low value-added and labor-intensive ones. But it will be a step necessary to control inflation and slow down money supply in China caused by trade surplus. On the other hand, import will steadily increase with a stronger Yuan and overall trade imbalance will shrink.
Faster appreciation of Yuan will help curb inflation in China, and it is a measure that I believe China has to adopt however reluctantly maybe. The straightforward reason is that other measures, such as raising interest rates, money supply control or even temporary price control are not fixing rampant price inflation. Inflation, at current level of 4%-5% with food and energy price growth well over 10%, is becoming not only an economic but politically sensitive issue in China.
As Yuan continues to appreciate and trade surplus starts to shrink, there will be less demand for the US bonds on the Chinese part. This could be a dangerous tipping point for the global economic system, in which the US had no difficulties of finding willing financiers from China and other emerging markets to fund both private and public debts. Without the Chinese support of the US debt market, interest rates will go up. The faster appreciation of Yuan’s appreciation vis-a-vis US dollars would make the US borrowing from overseas more difficult and will push up inflation in the US. Both of these events will seriously thwart the Fed’s efforts to rescue the US economy from slipping further.
I suspect that will have much wider impacts on the US economy than the current crippling credit and housing market. It will be a new dynamics that the US government and monetary policy makers have to confront.
Whether or not this scenario, like other “steps” listed by Roubini, will materialize is anybody’s guess. But my thinking is that the probability of this scenario has increased dramatically compared to that of a few months ago. It will be very ugly if this scenario indeed happens. Let’s hope not. But, on the other hand, it is not the worst thing either if it happens, as the global economic imbalance will be largely corrected and when the economy works its way out of the trouble for both the US and China, the growth will be well founded. One thing for sure, there will be a lot of changes in the process.
