20100624 No confidence in Chinese economy

No confidence in Chinese economy

Thursday, Jun 24, 2010, Page 8

If one country’s currency rises in value against another’s, people in the first country naturally become more confident in their economy and political system.

So, when Credit Suisse Group AG said yesterday that China’s yuan was almost 50 percent undervalued against the US dollar, it implied that China should have 50 percent more confidence in its economy and political system.

However, is this really so?

China had nearly US$2.5 trillion in foreign exchange reserve holdings as of March, which was not only the world’s largest, but also accounted for 27 percent of the world’s total. (As of last month, Taiwan had US$360 billion, the world’s fifth-largest.)

That will greatly boost China’s global influence, and, of course, its confidence.

However, the monstrous size of this capital is also cause for concern because it has nowhere to diversify besides US Treasury securities, some economists have said. A vicious cycle has surfaced in which China, which is already the biggest holder of US debt, has to keep buying that debt to bolster the value of its holdings as other countries dump their US holdings whenever the greenback weakens.

The more China builds up its foreign exchange reserves or its US debt holdings, the worse it will be victimized by a weakening US dollar, or, in other words, a stronger yuan. Simply put, should the yuan strengthen by 50 percent, the value of China’s foreign exchange reserves would immediately plummet by about 8.5 trillion yuan (US$1.25 trillion).

How and where would the Chinese government be able to absorb or offset losses of 8.5 trillion yuan, which represents one-quarter of the country’s GDP last year?

That is why some describe China’s holdings of US dollars as its biggest and riskiest bubble, compared with its already overheated property and stock markets. If its exchange policy is terribly managed, the likelihood of China becoming the next Greece-like default zone cannot be ruled out.

Of course, China doesn’t want that to happen, so it is expected to learn from the lessons of Taiwan and Japan. It would be naive to expect the People’s Bank of China, in the face of mounting international pressure, to manage a one-off adjustment of its currency.

Few really expect that China’s yuan will fully reflect its value anytime soon — at most, it will rise by a few percentage points, showing that confidence in China’s economy and political system isn’t as solid as expected. That is because China isn’t economically strong enough to replace the US and transform its global role from the world’s biggest manufacturer to the world’s biggest consumer with a stronger currency. Until Chinese consumers feel they have sufficient savings, or a social safety net is put in place as a buffer, it will take time before Chinese spenders begin a major buying spree.

A stronger yuan, on the other hand, would reduce global demand for goods and services made in China, as their competitive price advantage would disappear. The bulk of China’s red hot economic growth lies in the strength of its exports. If the world cuts its demand for Chinese goods, China’s economy will slow down. This is another reason Chinese authorities won’t allow the country’s currency to quickly appreciate.

With an undemocratic regime, rising wages, a currency facing appreciation and a widening gap between the rich and the poor, harsh challenges remain for China’s economy.