The China Vortex

In the past few days, Henry Paulson has come up with his US$700B proposal to save the major lending institutions which made bad decisions re CDOs, with all the bad loans being covered by the US taxpayer. This is happening at a time when the US middle class is under unprecedented pressure already.

Over the next year, all the bad decisions made by China’s economic planners over the past 30 years will show through. These include:

• The decision to become overly dependent on the US as an export market, and buying US treasuries to effectively buy this single captive market and continue to sell it goods far beyond its capacity to pay for China’s exports.
• Somewhere along the line, a decision was made to jumpstart China’s economy and put it on the fast-track of economic development. To a large extent, this has happened. But China’s economy is like a body builder whose upper body strength is massive, but has toothpick legs. More incidents like the melamine milk incidents will become common, simply because the government is not equipped to handle incidents of this kind.
• China, unfortunately, has a reputation for cheap, low-quality products, in spite of the successful Beijing Olympics. For the most part, Chinese companies do not have the talent to work up the value chain creating better products. (There are some, but they are too few to make a significant difference.) This takes time to build.
• Exports will slow, and the Chinese domestic market will not pick up the slack fast enough to prevent major unemployment problems, especially among university graduates.
• The wealth gap between the rich and poor will widen dangerously, and real estate prices, which are already falling, will fall even more.

China became addicted to US orders and the US dollar the same way Americans became addicted to Chinese junk products. (This is a generalization; many goods are not junk. But the general image is of, well, junk.) For both sides, it was a dream which was too good to be true.

Now it’s over, and the Beijing Olympics are turning into the final hurrah for that period.

If you would like a well-presented systematic presentation, my friend Corbett Wall has written an interesting piece.

The fat days are over, and we are in for a tough 20-30 years ahead.

An article in today’s Telegraph suggests that foreign central banks have sold US48B in US treasuries, with US32B in the past two weeks alone, according to figures released by the New York Federal Reserve. China currently holds US1,340B in reserves into other higher-yielding investments. Foremost among these newer investment vehicles is a sovereign-wealth fund.

China has bought US treasuries in order to secure its largest single export market. Effectively, China is lending money to its largest single buyer, since the American people have maxed out their credit. China is buying US treasuries so that Americans continue to have the capability to buy Chinese imports. Since the US dollar has been steadily falling in international markets, especially against the euro, this option is becoming less attractive.

In addition, China bought a large amount of US agency and corporate debt, some of which was backed by, you guessed it, subprime mortgages. For a detailed guesstimate (because it is not public information), take a look at this article by Brad Setser.

There is a good chance that there are some very senior people in Beijing taking a deep gulp as they look at their portfolio of dollar-denominated securities.

If so, that would explain the recent sell-off of US treasuries. And if they start selling, people in Washington are going to start worrying about how to handle US debt. Ultimately, Americans will have to recognize that they have lived beyond their means, and the US standard of living will have to make a downward adjustment, as is beginning to happen now.

So who wants to be president of the US in 2008?