China Loads up on Dollars

[William F Hummel <wfhummel@xxxxxxxxxxx>]

             The Fed is in a Dangerous Game with China
                From the Financial Times, July 30, 2004
                                     By Chen Zhao

The Federal Reserve is taking no half measures in its efforts to
stimulate economic recovery in the US. To ward off the spectre of
deflation, it is prepared to generate inflation and reflate the asset
bubble.

China is a silent but active partner in the Fed's pump-priming. It
would not be possible for US Treasury bond yields to be at current
levels were China not a willing and able supplier of savings to the
US. Combined annual purchases of Treasury securities from China and
Hong Kong have reached $290bn - more than those by any other creditor
nation. Both China and the US are having fun at this game. The flow of
Chinese savings has enabled Americans to borrow more and spend more.
Long-term bond yields are still very low, in spite of the recent bond
market shake-out. The refinancing boom continues. The collapse in
borrowing costs is reviving capital spending.

China is glad to see Americans going on another shopping spree. Its
factories are cranking up production at an unprecedented pace and
capacity is tightening. China's exports to the US jumped 35 per cent
in the first quarter compared with the first quarter of last year and
the trend is accelerating. The US's bilateral trade deficit with China
has reached $110bn, bigger than with any other country.

In effect, China is trading goods for US paper. The rapid accumulation
of Chinese reserves means the Chinese are buying dollars to keep their
own currency steady. This has allowed US interest rates to remain low,
which in turn has encouraged American consumers to buy more Chinese
goods.

This game of "trading goods for paper" creates a hyper-stimulative
environment for both countries' economies - which authorities on both
sides of the Pacific want. The Chinese and US currencies are falling
against the euro, money supply in both economies is going up and
interest rates are low. All of these are powerful stimulants for
economic growth and share prices.

So far there are no signs that the Chinese are about to change course.
Despite intensifying calls to revalue the currency, the authorities
recently increased the value added tax rebate for exporters. The
rebate amounts to a de facto devaluation aimed at providing
pre-emptive protection against a growing number of anti-dumping
investigations of Chinese exports. This action suggests that it is
naive to think the central bank will soon allow the currency to float
upwards.

Nevertheless, trading goods for paper works only up to a point. While
the game serves the purposes of Chinese and US policy makers alike, it
also creates enormous economic and financial distortions that are both
self-limiting and self-defeating.

With a collapse in interest rates fueling consumer spending, it is
conceivable that the US current account deficit will explode upwards.
There is no magic number the current account deficit must reach to
signal an impending crisis - but there has never been a nation that
has been able to increase its reliance on foreign savings without
eventually hitting a brick wall.

In the meantime, China will accumulate inflationary pressure. Its
economy has been booming for some time and foreign exchange
intervention has further fueled money and credit expansion. China has
already climbed out of deflation, with its consumer price index rising
at an annualized rate of 1 per cent. Granted, this is a very low
inflation rate. Still, with soaring money supply, surging exports,
expanding reserves, strengthening consumer spending and fast growth in
property investment, inflation will keep rising.

When will the party come to an end?  When the Chinese have had enough.
That will happen when inflation in China approaches 3-4 per cent -
which it could do within the next six months or so. At that point, the
central bank will be forced to revalue the currency.

Another potentially vicious shakeout in Treasury prices could be the
biggest implication of such a move. Revaluation would be deflationary
for China but inflationary for the US. Whether the Chinese economy
could withstand a higher exchange rate remains to be seen. But
revaluation would definitely help the Fed achieve higher inflation.

A further surge in bond yields could mark the start of the
long-foreseen demise of US consumer spending and damage the US
economy. This will probably be the moment when investors find out
whether the game is a boon for the world economy, or a bane that
merely defers another recession and bear market in stocks.