The conventional wisdom has it that the massive foreign currency
reserve held by China's government is primarily due to the US trade deficit,
and that the US economy will be in big trouble should China ever decide to
stop financing the trade deficit. As is often the case, this piece of
conventional wisdom is wrong.
Here are the facts. First, the US economy is in big trouble, but
the trouble has nothing to do with the trade deficit or the possibility that
China's government will dump some of its US$ holdings (the causes of the US
economic malaise have been detailed in previous TSI commentaries). Second,
China does not "finance" the US trade deficit. What happens is that
Chinese producers willingly send goods to the US in exchange for dollars. If
the manufacturers of Chinese goods are dissatisfied with this arrangement
then they have the choice of finding other customers or stopping production.
Third, the extraordinary size of China's official foreign currency reserve
($2.1 trillion and growing, about 70% of which is US$-denominated) stems from
the efforts that have been made over the years by China's government to
'manage' the Yuan's foreign exchange value. It works like this: A Chinese
company exports some stuff to the US and receives dollars in return, but most
of the company's costs are Yuan-denominated so the company trades these dollars
for the local currency. When this is done on a large scale it puts upward
pressure on the Yuan relative to the US$, which the Chinese Government wants
to resist. The government therefore buys the dollars using newly-created
Yuan, thus offsetting the upward pressure on the Yuan. In other words, to
keep the Yuan/USD rate at a certain level the government of China adds to its
USD reserves and simultaneously increases the Yuan supply. This not only has
the effect of reducing the Yuan/USD rate to below where it would otherwise
be, it also boosts prices within China. Fortunately or unfortunately,
depending on how you look at it (Keynesians and Monetarists would say
"fortunately" whereas members of the Austrian School would say
"unfortunately"), the prices that have been affected to the
greatest extent to date are the prices of investments (stocks, real estate
and capital goods).
In summary, the huge currency reserve amassed by China's
government is not a function of the US trade deficit; rather, it is a function
of China's efforts to prevent the trade situation from increasing the
relative value of the Yuan.
The conventional wisdom also has it that the economic stimulus
program implemented by China's government has worked, as evidenced by data
showing that its economy is again growing at a rapid pace.
The fact is that China's government has been able to create the
ILLUSION of success by setting in motion a dramatic expansion of the money
and credit supplies via the government-controlled banking system. Bad loans
are being piled on top of bad loans and new mal-investments are being piled
on top of earlier mal-investments, thus creating even more distortions within
an economy that is already labouring under the distortions created by
previous rampant credit expansion.
The following chart of China's M2 money supply tells an
important part of the story. The chart has a semi-log scale, so a straight
line on the chart would indicate a constant percentage rate of change. Notice
that over the 9-year period leading up to the final quarter of last year the
blue line representing M2 never deviated far from its long-term trend line
(drawn in red), meaning that the M2 growth rate remained fairly constant
throughout this period. Notice, as well, that the blue line has since moved
well above its long-term trend. The slope of the red line represents annual
growth of 16%-17%, which is very high but pales in comparison with the
current annual growth rate of 28%.
Chart Source: www.fullermoney.com
A sustainable increase in consumption must be preceded by an
increase in production (it is production, not consumption, that drives real
economic growth), but the corollary is not true in the situation where the
government encourages the economy to produce more of something for which
there is no end market. When increased production is prompted by government
directives and/or the creation of money/credit out of nothing, the thing that
will end up being consumed is the invested capital.
By throwing huge sums of money around and by forcing banks to
lend as if there were no tomorrow, China's government has stimulated
investment in factories, real estate and the stock market at a time when
existing factories are shutting down in droves, rental yields are very low
and the development of new real-estate projects is running well ahead of
sustainable demand, and the stock market is priced for perfection. We can be
sure that this story will end very badly, we just don't know when.
Steve
Saville
www.speculative-investor.com
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