StickWithANose

This post by Andy Xie is a long but fascinating read dealing with future prospects for China’s economy. I claim no expertise in global economic theory, but this is just too good to not pass on…

First Xie supplies some context:

In previous financial crises, big shots who contributed to bubbles went to jail; Americans expect heads on pikes after a financial crisis. Jailing even a few crooks is extremely important because it resets the system with a new psychology. For example, after the junk bond bubble burst in the 1980s, junk bond king Michael Milken and top executives at many bankrupt savings and loans went to jail. And after the IT bubble burst in 2000, jail terms were ordered for top guys at Enron, Tyco and even some Wall Street analysts.

The bubble that just burst was bigger than any in the past, yet none of the big shots went to jail. Instead, the president has dined with them and begged them to support his financial reforms. Americans see this as a farce. And if the Obama administration is unwilling to change, voters will choose someone else.

In addressing the financial crisis, Obama’s team continued a Bush administration policy aimed at protecting the status quo. Obama didn’t have to, but the government needed a financial system to protect the economy. It could have let the system go down before nationalizing it, leaving a clean sheet for a new system without the flaws that led to the bubble. Instead, the Obama administration created an enemy to its own financial reforms by bailing out the existing system wholesale. No one could expect the same people who benefited from the system’s flaws to support abolishing them…

On Obama’s new strategy:

With the Fed restricted by inflation and the government paralyzed by gridlock, the only policy option for the United States is to pursue export expansion…

One option for expanding exports is to devalue the dollar. But as the Fed enters a tightening cycle, the dollar can’t fall much. Indeed, as I wrote a few months ago, the dollar has bottomed. Its lowest point was in May 2008 when the dollar index reached 71, and it peaked during the crisis at 90 when safe haven trade pushed money into the dollar. It has been in the 75-80 range for the past six months, and will likely stay there for the rest of 2010.

As devaluation isn’t a way out, the United States will likely turn to trade policy to increase exports. China is the most obvious target. The yuan peg to the dollar is likely to be the focus again. During the crisis, the peg was a stabilizing force, preventing a total collapse of the dollar while the Fed maintained a zero interest rate. Now that financial stability has been restored, and the Fed is ready to raise interest rates, the yuan’s dollar peg isn’t as important to the stability of the dollar. Actually, it could make the dollar stronger than what the United States wants. So breaking the yuan-dollar peg is now in the best interest of the United States.

U.S. pressure over China’s exchange rate policy began with protectionist measures, such as tariffs on steel pipes, tires, poultry and electric blankets. Protectionist measures against China are so far worth several billion dollars, which is small relative to total imports from China and won’t create enough U.S. jobs to make a dent in the unemployment rate. But the publicity is good for Obama, who will likely step up protectionist measures. Since unemployment is a do-or-die issue for the administration, it must be seen as doing something…

Looking forward:

It is extremely likely the United States would push China to play the same role Japan played two decades ago. Its policy focus could be aimed at forcing China to double its currency value. But as the profitability of China’s export sector is already poor, the economy would face enormous pressure.

China is already experiencing a big property bubble. The overvaluation of China’s property stock may already exceed 100 percent GDP, higher than the peak excess value during the U.S. property bubble but still much lower than the 300 percent GDP overvaluation that Japan saw during its bubble period. So it is possible that China’s bubble may triple.

Even before lurching into a destructive property bubble, Japan was a high-income economy. China is still at a lower-middle income level, with a per capita income that’s one-tenth Japan’s. So a China property bubble bursts would stagnate the economy a la Japan but at a lower income level, trapping China at a low level, perhaps permanently.

However, it would be unwise not to respond to U.S. pressure constructively. Without benefiting from China’s growth, the United States lacks incentive to be China’s biggest export market. So to pressure China, I expect many more U.S. protectionist measures this year. Before the November mid-term election, Congress could pass a bill that calls for a 30 percent tariff on all Chinese products unless China appreciates its currency by the same amount.

Not sure what I make of that last one. I think that Xie has a little too much faith in our esteemed Congress to actually do something, especially policies that would face the stiff wind of corporate lobbying.

Otherwise, it’s a fascinating essay, and its worth your time to read. We live in interesting times for sure…