Rising Dragon? A Closer Look at China

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by Joshua Enomoto, Founder of ContangoDown.com and FutureMoneyTrends.com contributor

Amidst global volatility that has finally scratched the surface of the U.S. equities sector, all eyes are squarely focused on China: it’s weakening growth numbers have severely impacted investor sentiment in Japan and throughout Asia, and will eventually affect the United States regardless of whether the stock market valuation is lagging behind reality or not. China being the number two economy in the world will by default deserve considerable attention, but it’s important to note the context by which it achieved this lofty status to forecast its next transitional shift.

First, we must understand that China is a replication economy, one that thrives on providing useful goods cheaper. According to an article by Rediff Business, Chinese suppression of the yuan has significantly hurt the exporting potential of India, who also competes in the “replication sector,” both in terms of manufacturing and human labor. Second, the lack of an innovation base in China means that their economy is overly leveraged on exports based on price. According to the Wall Street Journal:

“In a new paper, “How Much Do Exports Matter For China’s Growth?”, three researchers at the Hong Kong Monetary Authority revisit this question. It’s a live issue, as new data show that while exports continued to contract for a fifth straight month in March, the housing market has started to show signs of life.

The paper builds on previous work by one of the authors, Li Cui, who in a 2007 working paper for the International Monetary Fund presented evidence that China was becoming more dependent on external demand over time. Indeed, net exports contributed about 20% of China’s economic growth from 2005 to 2007, compared to less than 10% in the previous five years.

But the authors of the new paper try to go beyond that number to capture the total effect of the export manufacturing sector on the economy, including investment in new factories by exporters, and spending by people employed in those factories. That leads them to conclude that the spill-over effects from the export sector are in fact quite large.

The authors estimate that a decline of 10 percentage points in export growth would be associated with a decline of about 2.5 percentage points in GDP growth. “This is about at least twice as large as what could have been expected if only the direct impact of exports is considered,” they write.

Part of the explanation, they say, is that exports are extremely important to a group of Chinese coastal provinces, which themselves account for the majority of the national economy. So changes in export demand can cause dramatic fluctuations in those regional economies, even while the inland provinces are less affected.”

Under a price paradigm, a key driver for growth is the currency rate, or more bluntly, currency manipulation. The yuan is unique in the sense that its exchange rate can remain extremely flat for years, then spiking in valuation, followed by more years of static price action.

For nearly a decade between 1996 and 2005 , the yuan against the US dollar remained at a flat rate of approximately 0.121. However, in the later half of 2005 through 2009, the yuan gained 21% of valuation against the dollar, which also coincided with the tremendous growth spurt witnessed in the Asian giant, where double-digit gains in GDP were the norm. From the collapse of 2008 until late 2010, the yuan was again artificially frozen at a rate of 0.147. The commodities bull market and the Federal Reserve’s aggressive protocol of QE2 ensured that the yuan took another rise up, this time an 11% increase from 2010 until now.

The question becomes, will the uptrend in the yuan, despite the government of China’s best efforts, continue on its course? In the immediate term, it appears likely. Taking a look at the yuan as a measurement of dollars (“price” going down in the below chart indicates strength for the USD), the Chinese currency moved up 1.5% between February and June of this year.

This rise of strength coincided with a skyward move of the US dollar, launched there by the Japanese Yen as the Bank of Japan initiated its wave of aggressive rhetoric and monetary policies. While the USD/YEN pair has given up a good chunk of those gains due to an overheating of the FOREX carry-trade, the commitment for hitting a 2% inflation target remains strong by the current Japanese leadership, which indicates that the rise in Yen is merely a correction against a long-term trend of future weakness.

The rising of the U.S. 10-year yields amidst the backdrop of an improving housing market and some economic metrics, followed by rumors of the Federal Reserve tapering off its QE program, are all warning signs that the dollar will ultimately rise in value. Even if the Fed Chairman Ben Bernanke decides to continue with quantitative easing, the higher yields may prove far too tempting for Japanese investors, which would theoretically be greenback bullish, yen bearish.

Because China is “price-sensitive,” a further rise in the yuan may prove crippling, especially given its recent slowdown in growth. For now, the government may allow the currency to float and gain value, which does have the benefit of increasing the purchasing power of its billion-strong citizenry. From a technical perspective, the yuan could rise another 13% before hitting historical highs:

If the yuan does rise, the next query would be higher or lower? For once, a potential answer to this question has found alignment both in the mainstream media as well as the conspiratorial press: Gordan Chang, who writes for Forbes.com, and Mac Slavo, a contributor for Alex Jones’ Infowars, have cited a massive increase in retail demand for gold bullion. According to Mr. Slavo’s headline, 10,000 people waited in line for their chance to purchase precious metals, while Mr. Chang, in his article, “China Goes Gold Crazy. Why Now?”states that recent gold demand was five times higher than normal.

The two articles cite a similar trend but different conclusions: Mr. Chang speculates that communal concerns over the fragility of the Chinese economy has prompted the bullion craze, while Mr. Slavo takes a decidedly more conspiratorial angle, suggesting that what we see in China will happen throughout the world as global central banks lose complete control of their economies.

My conclusion is that the Chinese people are anticipating a new wave of inflationary policies: I believe, perhaps from personal bias, that the Chinese are generally business savvy people that want to lock in their 32% capital gains profit from holding the yuan and the best way to do that is to acquire gold bullion. The wave of retail demand, therefore, is indicative of the rational pursuit of yields rather than fear of the Apocalypse. And really, who can blame them? After all, the U.S. military is not out stealing secrets from China…they are stealing from us, another confirmation that China is a replicating economy, not an innovative one.

Ironically, China’s gold hoarding represents a national security risk to themselves: if more Chinese workers are spending a significant portion of their income towards a deflationary asset like gold (deflationary because it takes cash out of circulation and freezes it into a non-yielding physical entity), this would exert immediate pressure on domestic consumer demand. This in turn would place more pressure on China’s exporting prowess, already under stress from a rising yuan. The cure? An artificially weaker yuan. And with the dollar poised to move higher, and the yen poised to move lower, China may not have much choice in the matter. Also, as Intellihub.com eloquently points out, China’s illegal reproduction of American Silver Eagles, which are actually legal tender in the U.S., represents an act of war. The Chinese may actually be buying fake gold and silver bullion, thus creating deflation for absolutely no benefit!

A weaker yuan will initially be positive for the Chinese economy, but as the dollar grows stronger, the influence that the individual Chinese worker can exert would be lessened, thus giving American consumers far more choices. This should benefit countries that have a favorable stance towards the U.S., particularly Japan, India, and Vietnam. Further, the American people will likely only tolerate Chinese aggression for so long: a shift towards political conservatism may be the beginning of the final step towards addressing this very serious threat.

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