China has a unique opportunity and responsibility to shape not only its own
future, but also that of the global economy. While the country is by no means
responsible for the plight the world faces, it has played an important role in
allowing global imbalances to be built.
If China decides to help prop up the world economic model that got us into
trouble in the first place, we may face the same challenges again a few years
down the road. Except then, China may not have US$2 trillion in reserves to
rescue its economy, and could face severe challenges. China will ultimately act
in its own best interest, but prudent she must be. The time for China to act is
now.
Because of the country's fiscal health, policy makers in China
have far more flexibility to turn the global financial crisis into an
opportunity than do their US counterparts. Currently, US policymakers
mistakenly think they have all the flexibility in the world because of what is
perceived to be an almighty Federal Reserve. In our assessment, the law of
unintended consequences is likely to hit the US hard: debt monetization will
cause inflation; economic growth will falter once the Fed tries to mop up all
the liquidity it is throwing at the economy; and the wealth gap will increase
further as the wealthy refinance their debt taking advantage of artificially
low interest rates, whereas the middle class slides further into recession as
they remain locked out from the credit markets.
Policies to prevent the middle class from de-leveraging will backfire, causing
not just economic misery, but the rise of populist politicians. While these
policy mistakes are tragic in the US, similar mistakes in China could be
catastrophic.
The greatest challenge of a negative feedback loop in an economic downturn is
demand destruction. A depression is a state of mind - consumers and businesses
are reducing their risk appetite and switch to survival mode no matter how low
interest rates are. Banks are more interested in buying government bonds with
capital injections received than in lending to the private sector. Uncertainty
is a key contributor to demand destruction. US policies are not as effective as
policy makers would like them to be because for too long there has been a lack
of leadership to communicate how this crisis will be managed.
A US Congress willing to give a US$34 billion "bridge loan" to automakers
knowing very well that the money will be spent within months while not placing
car makers on a sound footing is a Congress building bridges to nowhere.
Speaker of the House Nancy Pelosi said the loan would get the industry ready
for the 21st century; we are almost a decade into the new century - this effort
is too little too late. Worse, even if there were a magic wand to heal the
carmakers, 0% financing on six-year loans extended during the credit bubble
depresses demand for years to come.
Similarly, the stimulus plans to be enacted in January are unlikely to be as
effective as intended; foremost, the plans are expensive and should push up the
cost of financing for government debt.
The US Treasury has been at the forefront of the crisis, but any leadership
taken was not properly communicated. The result is, again, that policies have
mostly been expensive but have failed to unlock credit markets. Too often have
the Treasury's rules changed; the policies in place continue to discourage
private sector participation in helping to recapitalize financial institutions.
Lou Jiwei, chairman of China Investment Corp, the country's sovereign wealth
fund, put it bluntly: "Right now we don't have the courage to invest in
financial institutions because we don't know what problems we will put
ourselves into." He spoke ahead of US Treasury Secretary Hank Paulson's visit
to China last week and added, "My confidence should come from government
policies. But if they are changing every week, how can you expect that to make
me confident?"
The only leadership that seems to be emerging is from the Federal Reserve
determined to print not just billions, but trillions of dollars to provide the
backstop to all economic activity; at the same time the policies are an insult
to any potential buyer of securities the Fed has targeted, as the intervention
keeps yields artificially low.
As China has been one of the premier buyers of these securities, namely
Treasury bonds and agency securities, this is a clear message by the Fed that
Chinese investments to finance US deficits is no longer welcome; why else would
the Fed depress the return for potential buyers during a time when
unprecedented amounts of debt need to be raised?
While we are provocative in our allegation, it is at best an unintended
consequence, at worst highly deliberate. Intentional or not, it may coerce
Asian buyers of US debt to reduce their holdings to allow the US dollar to
weaken. The Fed may believe that it does not need the free market to set rates
as it can use its own balance sheet to set economic policy; this ill-perceived
view is also shared by economists who believe modern central banking is
stronger than market forces.
China can learn from these mistakes, but has no time to lose. Demand
destruction in China is working its way through the economy there as well. The
window for Chinese policy makers to lift the spirit of workers is closing fast:
the holiday based on the Lunar New Year, falling in 2009 on January 26, is an
opportunity for workers to reunite with their family and friends; during those
days, the mood of the country will be set for the year. Right now, stagnating
wages, job losses and the bleak US economy will dominate the dinner-table
discussions. Consumer spending in China has continued to hold up year over
year, but there is a seriously accelerating slowdown under way. Far more
effective than a spending program on infrastructure is a program to lift the
spirit of Chinese consumers.
Dong this is not best done by providing access to credit, but by giving the
country a vision. It is already abundantly clear that the toy industry is
faltering; but the high-tech industry in China is performing well under the
circumstances. In its recent history, China has embraced change and must do so
now. This is the opportunity to get the country ready for the next phase in its
economic growth. To do so, rather than subsidizing industries that have little
chance to survive, the country should focus on where its strengths are likely
to be in the years to come.
China has a tremendous opportunity as the outsourcing partner for goods and
services at the higher end of the value chain. Toy production should be left to
other Asian countries; China has to focus on technology and innovation.
Similarly, while building roads and power plants may provide a buffer to an
economic slowdown, policies are required to encourage Chinese entrepreneurs to
take risks and invest. An infrastructure stimulus plan will favor state
controlled enterprises; to turn the mood in the country, government policies
have to provide the general population with a vision, not merely state owned
enterprises.
Once a vision for the future is embraced, it will become apparent that it is in
China's interest to allow the yuan to appreciate. In early 2007, the European
Union surpassed the US as China's primary export market. The close link between
the yuan and the dollar reinforces the public's perception that the fate of the
Chinese economy is linked to that of the US; China has to become more self
confident; removing the shackles of the current exchange rate regime may
provide an important catalyst to energize a spirit of change.
While a stronger currency would hurt industries that mostly compete on price,
such as the toy industry, it would substantially increase the domestic
purchasing power. The future of China is a more balanced economy with a
stronger domestic sector as well as an export sector that competes on value,
not price. China does not want to face the challenges of Vietnam, which
competes only on price, ending up with extraordinary inflation and, ultimately,
unable to sell to the US anyway because American consumers cannot afford their
mortgages.
China is not powerful enough to prop up US consumer spending; as a result, it
is far more efficient for China to use its reserves to help transition the
economy for the future rather than use its reserves to buy US government
securities to stimulate the US economy. The Fed has decided to take China's
place in buying US debt; let the Fed pursue its dangerous experiment. In the
meantime, China should position itself for the future as the road ahead will,
without a doubt, be rough.
Axel Merk is manager of the Merk Hard Currency Fund,
www.merkfund.com.
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