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Fantasy Land!

"Houston, we have a problem! Our people continue to import cheap foreign goods to satisfy their cravings. Our current account deficit is expanding rapidly and the whole world is watching. Therefore, we must hold "someone" responsible. Aha! Why not blame the Chinese for all our economic woes? After all, they are the ones who are keeping the Yuan pegged to our currency at what we think is an artificially depressed level. Those communists, they must be blamed!" - Welcome, you are now inside an American politician's brain, otherwise known as Fantasy Land!

Over the past few months, America and indeed Europe have been exerting intense political pressure on China to revalue its currency against the US dollar. Suddenly, China is being held responsible for all the imbalances our global economy faces today. The "cheap" Yuan is being hailed as the villain in our modern society. America is talking about imposing tariffs and eventual embargos against Chinese imports. The thesis is that a stronger Yuan will make Chinese goods more expensive and discourage American imports, thereby addressing America's record-high current account deficit.

Politicians, policymakers, prominent media broadcasters all seem convinced that a stronger Yuan will reduce American imports and make its own goods more attractive in the international playground. They are all living in a dream world. In the real world, American manufacturers cannot compete with their Chinese counterparts even if they tried. In the real world, American wages on average are about 30 TIMES higher than those of China. In the real world, Americans are dependent if not addicted to cheap imported goods. In the real world, expensive Chinese goods will send American retail prices and interest-rates through the roof. In the real world, any meaningful strength in the Chinese Yuan will prick the debt and property bubbles in the US!

Politicians can exert as much pressure as they want but I am afraid China is an economic powerhouse and will do as it wants and in its own sweet time. To put it simply, China's priority is to keep its own people happy and employed. And I emphasise the word employed here. China needs to create roughly 1.2 million jobs each year to keep its employment situation under control and a "cheap" Yuan allows it to do just that. Now, I do not know about you but if I was a Chinese leader, I would keep things just the way they are despite pressure from overseas. After all, the world's oldest civilisation has come alive and its economy is growing rapidly. Like it or not - the sleeping giant has awakened and will rule the world (at least economically) for the coming century. The 19th century belonged to the British, Americans took charge of the 20th century and the 21st century will see the rise of China.

Here are some facts to illustrate my point -

• China has a trade and current account surplus; US has record deficits
• China has record-high foreign exchange reserves; US has a record budget-deficit
• China is the 2nd largest creditor nation; US is the largest debtor nationin the world
• China has a savings rate of 30%; US savings rate sits at a miniscule 1%
• China invests in capital formation; US "invests" in consumer spending

In a nutshell, the US economy is living on borrowed time. Foreigners own around US$9 trillion worth of American assets whereas American assets in foreign countries are valued at US$6 trillion - a negative net-asset balance of US$3 trillion or roughly 30% of American GDP. Slowly but surely, more and more of America Inc. is now being owned by non-Americans and this is affecting America's biggest export - the dollar. To put it simply - The US is at the mercy of its "foreign friends".

Next, take a look at the facts provided below -

• China produces more steel than the US and Japan combined
• China produces 5 times more cement than the US
• China consumes 21% of the world's copper and 27% of the world's iron ore
• China's sugar imports doubled in the past year (1.3 million tonnes)

The world's fastest growing country is also the most populated. You can do the math yourself, but it is obvious to me that even a small increase in China's consumption patterns will create huge demand and surging prices. Already, despite a depressed per-capita consumption of oil (1.7 barrels per year), China has surpassed Japan and become the 2nd largest oil consumer.

The point I am trying to make here is that China is a robust economy and a huge market. Yes, it has problems with its banking sector and a hard landing is likely but this will only be a temporary setback.

The recent jawboning by the West is nothing more than government propaganda to keep their own manufacturers happy. This may sound harsh but America may want to look inwards for its economic problems. Forcing China to revalue its currency will not increase the American savings rate nor will it make American producers more competitive overseas.

Furthermore, According to the US Department of Commerce, American exports to China in 2004 stood at US$ 34.7 billion while its imports from China came in at US$ 210.5 billion, representing a trade deficit of US$ 175.8 billion against China. Now, if you look at the chart provided below, you will realise that America's total trade deficit is a staggering US$ 700 billion! This clearly demonstrates that although China is partly responsible for the American deficit, America's deficit with China only constitutes 25% of its overall deficit. Therefore, pointing fingers at China and blaming it entirely for American deficits is not a fair allegation.

Next, take a look at the chart provided below. It clearly shows that in direct contrast to America, China has a record-high trade surplus - a sign of a healthy economy. China's deficit first turned into a sustainable surplus in 1994 and since then this trade surplus has expanded. The technology bust and the US recession at the turn of the millennium caused some jitters but the overall trend remains up.

I may warn that excessive pressure may push the Chinese leaders "over the edge". So far China has been a major supporter of the US dollar. In an effort to keep its own currency low against the US dollar, China has bought billions of dollars of US Treasuries. In fact, China is now the 2nd largest holder of US Treasuries after Japan with holdings of roughly US$ 225 billion. If China indeed let its currency float, it will have absolutely no need to support the US dollar and may decide to dump their US Treasury holdings. Such an act will cause havoc in the US bond market and will raise long-term interest-rates significantly. The mortgage rate in America is dependent on the yield of the 10-Year Treasury-Note. A collapsing bond market and surging interest-rates in America will end the housing boom and create economic chaos.

In summary, it would be advisable for the American administration to take responsibility of their own economic imbalances and actually thank China for supporting their currency and for allowing the American public to keep consuming cheap imported goods.

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