Eye on China: US to lose big in any Chinese economic rejig

With interest rates reportedly close to peaking in the United States and the new Fed chairman Ben Bernanke suggesting Americans have little fear of a house price collapse, all would appear to bode well for this year.

China's effect on the global economy worries me, however. Its rise in status to be the fourth-largest economy in the world after the 20 per cent GDP revision early this year rattled me. When China bolted past the United Kingdom, for long the standard bearer of Anglo-Saxon economic dynamism in Europe, it was a shock.

Note that this stellar performance is not based on purchasing power parity, which takes into account lower prices in China and artificially boosts the size of GDP to compensate, but in absolute terms.

It's not surprising the US is afraid of China, but it may be playing its cards in completely the wrong way.

The US has been accusing China for years of undermining the American manufacturing base through keeping the yuan artificially low. This basically boosts Chinese exports and wipes out domestic US companies.

The US has called long and hard for Chinese currency reform, allowing the yuan to appreciate by 20 per cent or more, which should permit a reduction in the trade deficit. But a reduction in China's trade surplus (of which the US component comprises a full 25 per cent) will reduce China's ability to export capital.

That could mean a good deal less capital to fuel the US deficits.

The Americans certainly have cause for complaint that the Chinese are manipulating the currency, but the cure could be far more catastrophic than the existing situation.

Recall that the game works like this: the Chinese (and other Asian exporting countries) depress their currencies relative to the US dollar by selling the former and buying the latter. That's important for keeping the prices of Chinese exports low and, hence, boosting the contribution of exports to growth. Indeed, exports contributed half of Chinese growth in 2005, according to the International Monetary Fund.

In a country where the Government's very existence depends on providing jobs for the vast population, the importance of the export sector would appear to be huge.

The resulting trade surplus has permitted enormous flows of capital into US treasuries and stocks, enabling President George Bush to fight the Iraq war and ordinary Americans to binge on real estate.

Cheap capital has enabled the US to post growth rates just as astonishing as China's, given America is already the largest economy in the world. In return, the Chinese have assured their export markets by keeping prices low.

But Chinese efforts to reform their economy could undermine the cozy status quo. And the biggest likely loser could be the US.

The Chinese Government is taking heed of warnings that GDP growth driven by pouring money into industrial capacity is not the best long-term bet. This kind of investment, known as fixed asset investment (FAI), has contributed up to half of China's GDP growth in recent years. Investment in FAI is linked to exports, because domestic manufacturers with overcapacity have switched to exporting to fully utilise capacity.

This could be changing. The new agenda in China is about how to boost domestic consumption. Increasing consumption would generate GDP growth and permit a slackening off of increasingly wasteful and environmentally damaging investments in the industrial sector and, hence, a decrease in exports. A decrease in exports, reducing the US$200 billion ($299 billion) trade deficit with China, would be politically, as well as economically, advantageous, at least until the US realised that the American trade deficit was precisely what was funding Chinese capital flows. Prioritising consumption would also encourage moves for a stronger yuan, since it would make importers of foreign goods cheaper.

Another indicator of slowing exports in the future is the fact that Chinese state-owned companies have been instructed to pay dividends. Previously, they dumped their earnings with the banks, adding to the excess liquidity funding over-capacity.

This will, ultimately, raise the cost of capital for Chinese manufacturers and reduce prospects in the export markets. That will also make it less important for the Chinese Government to push down the value of its currency through investments in US securities.

If increasingly wealthy individual consumers start unlocking their savings and contributing to GDP growth through consumption, then the contribution of exports to GDP will be further undermined. Using its US$800 billion forex reserves to keep the US dollar high relative to the yuan will become less important and forex reserves will, in any case, begin to decline as export earnings decrease. The domestic market will become a relatively far more powerful factor in growth, just as in the US and Japan.

The formula is simple: Reducing exports and increasing consumption will reduce the capital available (obtained through trade surpluses) for China to fund the US's huge deficits. Thus would the US be hoist by its own petard.

The obvious question is where this will leave the US. What will US asset prices do when they stop being underpinned by Chinese flows into the US stock and bond markets?

The obvious answer is that when the cheap money slows, asset values (house prices but also stocks) will tumble, with a potentially catastrophic follow-on effect on the rest of the US economy. It would also make expensive wars of the kind loved by Bush and his cronies harder to fund.

There are plenty of reasons this disaster scenario won't be fulfilled. Japan still keeps its currency undervalued through buying up US T-bonds and has signally failed to change its costive population into free-spending Americans.

But the point remains that China's size makes many unpleasant options more likely. That's why I was rattled by the increase in the size of the Chinese economy announced by the Government. China is starting to fulfil its potential and that growing power could rewrite the global balance of power much sooner than we think.

* Each week the Business Herald's columnists track the latest developments in the world's two emerging economic superpowers. This week, Beijing-based journalist Dan Slater gives his view.