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Three Chestnuts in the Morning, Four in the Afternoon
Perspective on the News
Monday, April 26, 2010
Ed DeShields

There is a Chinese proverb about a man who liked monkeys.  As the story goes, he had a lot of them in his house.  He understood his monkeys and the monkeys understood him.

However, it cost a lot of money to care for all those monkeys and he was afraid to stop buying them food in fear they would be upset.

So one day he tried to reason with his monkeys.  “Monkeys, today I’ll give you three chestnuts in the morning and four in the afternoon,” he told them.   But, the monkeys didn’t like that.  After a moment he offered, “Then it shall be four in the morning and three in the afternoon!”  

And, the monkeys were happy.

For a thousand years, China has used this proverb to teach its people a valuable lesson about trade.   And while the United States isn’t exactly a bunch of monkeys, our trading partner is more man than monkey. 

China’s growth is created when we borrow Chinese money (in the form of U.S. Treasuries) to buy Chinese goods, which means that Chinese growth has become dependent on that very same borrowing.   In the meantime, America’s debt is being held by a politically run Chinese economic system with a growing economic bubble being stimulated by the Chinese government. 

Why is China doing this?  Because, like the man in the proverb China must keep its people happy despite being in an untenable position with its internal resources.  It has to keep its economy going, despite the damage it’s doing to its own balance sheet.  It must artificially stimulate its own economy hoping to buy itself time until the global economic shipwreck rights itself.  

Politically speaking, China is not like the rest of the world.  Millions of people have migrated to its cities and now many are hungry and unemployed.

China’s biggest cities are twenty-first century marvels.  Vast amounts of capital have poured into the new China and most of it has gone into modernizing its infrastructure and fueling its speculative real estate boom. 

The typical Chinese urban condo is 100 square meters, about 1,100 square feet.  A condominium with no floors, no walls and no appliances costs the average Chinese two-income couple USD$100 to $150 per square foot.

Yet, dual incomes families earn only $7,500 per capita in China’s urban areas.  A quick examination of this mismatch means that most cannot afford the housing stock China has created in its cities.    There’s not a single American that does not understand this math having learned from our own housing crisis.  

And we know how that ended.

People without housing, food or work will eventually riot.  To keep that from happening, the government is more than willing to artificially stimulate the economy by literally forcing banks to lend -- which creates billions in bad loans on top of the ones they've originated over the last decade.  In China, the government can force banks to lend; a government power only Obama would envy. 

Therefore much of China's growth is non-sustainable.  And this growth will result in a heavy price to be paid by the Chinese in the near future.  The only question is when and how much.

A chestnut economic policy makes matter worse.  China sells goods to the United States and receives dollars in exchange.  If China were to follow the natural order of things, it will have to convert those dollars to renminbi (i.e. sell dollars and buy renminbi) and the dollar will decline and renminbi will rise making Chinese goods more expensive in dollars and less price-competitive.   When China’s exports slow, its economy will slow and the air in the bubble will be released in an orderly manner. 

But China is choosing a different strategy.  Instead of exchanging dollars back into renminbi and thus driving the dollar down and the renminbi up -- the natural order of things -- China is parking its money in the dollar by buying Treasuries.  And in doing so, it artificially props up the dollar.   Why?  Because China is sitting on 2.2 trillion of them. 

China is facing a very delicate situation:  It needs the money internally to finance its own ponzi-based growth.  However, if it were to sell its dollar-denominated treasuries, bad things would happen.   Its currency would skyrocket losing its low-cost-producer edge in the world and U.S. interest rates would increase dramatically.  It’s neither good for its biggest customer, nor good for itself.    This is why China is desperately trying to figure out how to withdraw its funds from the dollar without driving it down. 

And the Obama administration isn’t helping.  It has its own problems.  The Fed is printing money and issuing Treasuries at the fastest rate in history and depending on China to keep buying them.   If China reduces or halts its buying of Treasuries, the game is over.  

That spells big trouble.  And, the monkeys will not be happy.   

About Ed DeShields  

Last Week: El error de Diciembre

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