Currency issues have been at the center of relations between the US and China since the end of last year. Earlier this month the Obama administration chose not to name China as a ‘currency manipulator.’ Doing so would have opened the door to imposing heavy tariffs on Chinese imports. The next day, China’s State Administration of Foreign Exchange announced that it would not divest its US Treasury holdings.
However, it is clear that China will pay first attention to keeping its own domestic house in order, with international considerations being only secondary. This is the source of now-latent but continuing tension with the US over economic issues; and the international effects of Chinese domestic economic policy are not limited to the US.
Background to discord
Five weeks ago, just before the G-20 summit in Canada, China announced that it would relax controls on the yuan, allowing it to fluctuate against the dollar, in order to remove the topic from the meeting’s agenda. There was a one-day run-up, but the day after that the Chinese authorities intervened in the market to draft the currency back down, as a warning that they will not allow significant fluctuation even after taking it off the dollar peg.
Adam Wolfe, a research analyst for China and geopolitics at Roubini Global Economics (RGE), tells ISN Security Watch that RGE expects the yuan to “only gradually appreciate against the dollar,” at a rate of 3-4 percent per year, “with some periods of depreciation if there is a flight-to-safety event and the euro falls against the dollar.”
As a result, Wolfe expects little effect on “political support in the US for trade restrictions and tariffs against Chinese goods.” Slow appreciation of the yuan against the dollar “will likewise do little for global rebalancing,” he says.
Since Chinese economic statistics are reported on a year-on-year basis, when the government reported that GDP expanded 10.3 percent in the second quarter of this year, that amount was the increase over the second quarter of last year.
The first quarter statistic was 11.9 percent, and Credit Suisse’s chief economist for Asia (excluding Japan), Dong Tao, expects this to fall to 6.7 percent by the end of the year. That is lower than many other estimates, but there is a shared consensus that the rate of growth will decline.
As Wolfe notes for example, “Nearly 50% of China’s GDP comes from investment, and as stimulus-related projects are completed and real-estate investments shift toward lower margin projects like public housing, investment growth will slow.”
Chinese housing: ‘bubble’ or not?
Wolfe explains the economic policy tug-of-war within China itself as being “a political battle between Party officials in Beijing who would like to gain greater control of credit growth to put a lid on inflationary pressures and local officials who would like to continue using banks to fund investment projects in their regions to boost GDP growth and investment.”
Beijing has the upper hand over the regions for now but this could change by the end of the year, Wolfe says, as “China’s political business cycle is one of growth generated by local expansionary policies that eventually leads to inflation, then Beijing clamps down on credit growth to choke off inflation.” After stagnation ensues, the center eases up on credit and then the regions begin to drive growth again.
A widespread concern is the Chinese real estate market. Fears are of a bubble that, if it crashes, could extend beyond China and affect the global recovery from the 2008 meltdown. The recent run-up in the Shanghai stock market has been partly driven by property developers. Consequently, any government tightening of fiscal policy or other restraint upon the real estate sector could negatively affect anticipated earnings and so also equities at large.
Wolfe affirms that a housing bubble exists “at the high-end of the market in some Chinese cities,” but maintains that “there is not a nationwide bubble.” He acknowledges that price inflation in the housing sector will likely continue “as long as China’s financial system remains repressed and local governments remain overly reliant on property transactions fees for their funding.”
Bases for future conflict
Domestically, some of the nascent middle class have made speculative investments in real estate, much like their American counterparts did earlier in the decade. Increased urbanization will help to work off some of the oversupply in most of these markets,” Wolfe says, “and the government’s push for more affordable housing is a step in the right direction.”
Any weakness in the housing market would affect not just the Shanghai stock market but also the Chinese economy as a whole. Housing accounts for about half of China’s steel demand, a third of the aluminum, and also a significant part of the cement industry. Were a housing bubble to burst, demand for all these primary materials would fall.
The housing sector is also a sensitive subject more broadly internationally because of the reliance on the Chinese market by raw materials producers, particularly metals and mining. The Credit Suisse economist Tao now estimates that commodity demand from China will be “very volatile” between now and the end of 2011 as its economy slows, and “is not going to be as bullish as many people believe.”
Moreover, Wolfe notes that exports “will face headwinds from a deleveraging U.S. consumer and EU fiscal austerity in the second half of 2010.” This is significant because China’s central bank advisor Zhou Qiren recently said in an interview carried in a Japanese newspaper that Beijing will let the yuan weaken if exports fall sharply. That would bring the currency conflict with the US back front and center.