Monday, March 26, 2007

The Chinese problem

Everyone in the investing world needs to have a basic understanding of our trade situation with China. It boils down to this. We buy stuff from Walmart,Target etc who buys their inventory largely from China. So essentially China is sending us stuff and we are sending them dollars. What can a manufacturer in China do with dollars? Well, they can buy US imports, they can buy US financial assets (stocks and bonds or real estate) or they can trade them for Yuan or other currency on the Forex market. As most people know, we have a significant trade deficit with China which means that the Chinese typically do not use their dollars to buy US goods and services. They typically buy US treasury bonds which is essentially saving in the US dollar currency.

This dollar build-up should have a natural brake on itself. Eventually, the excess amount of dollars should cause the dollar to drop (via supply and demand). This makes Chinese goods more expensive to Americans and so should decrease their buying. However, it hasn't exactly worked out that way. The Chinese central banks has been inflating their currency by printing as many Yuan and trading them for dollars as it takes to keep the Yuan from appreciating so that Americans do not stop buying and the Chinese can grow their export-led economy at a very fast pace.

Can this go on forever? Can the Chinese keep growing their factory base at 10% if US consumption only grows at 4%? Not unless the Chinese or someone picks up their consumption. It is unlikely that the Chinese and the rest of the world are going to change that quickly. The Chinese are new to this capitalism thing. They still lack basic property rights, a solid sytem of business law, a strong financial system. Most importantly, the Chinese lack a basic sense of political and economic security. Without this security, they will opt to save rather than consume.

This should lead to dire consequences for China. Eventually they will develop excess capacity. This means they will have too many factories making too many products and not enough Americans or anyone else to buy them. This is the classic economic problem which leads to recession. When the excess is large enough, it leads to a depression. Whether or not this is a mild to medium recession or a more severe depression (like the Great Depression) may depend on the stability of the Chinese financial system. I don't have much knowledge about this but the general concensus is that the Chinese banks are plagued by corruption and nearly insolvent. So you can easily see what could go wrong for the Chinese. They need to support their growing economy with growing consumption but don't seem to be able to do so.

What can the Chinese do to prevent this? I would argue very little. I think it is enevitable that they undergo a recession. They can further inflate their currency which lowers prices for Americans. However this doesn't work out as planned. They still need to buy oil, energy and commodities from outside of China. Cheapening the currency just makes these more expensive. That is, inflation is never a solution. It can add a temporary stimulus but cannot really benefit the real economy.

A better way to look at all of this is without the use of currencies. Currencies can add another layer of complexity that act to obscure the real issues. Basically the real issue is this. As global markets have opened up over the last few decaded, poor people (like the Chinese) have been able to get jobs servicing the people in the more developed nations (like the US). Since they were poor, and had little access to jobs, they were willing to work for less pay. It is just supply and demand. There are lots of skilled but jobless Chinese willing to work all day to pay for their rent and dinners and the global economy has found a way to allow these people to service the richer American people. As long as there are more Chinese people (or in general poor people anywhere) than jobs, their wages will remain low. They simply have no bargaining power to ask for higher wages if their employers (ultimately the rich consumers) can go elsewhere for work.

This will end when we run out of poor unemployed people. Once that happens, they will demand higher wages and they will get them. This will cause higher prices for the rich Americans. In the mean time, the poor will have been saving their money and will be less poor. Ultimately, they will be as rich as the Americans. Overall, this is good for everybody. That is the whole point of the field of Economics. Trade is good for everybody. Isn't this great how trade solves all problems? Well...