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"In economic theory, China's currency should rise in value since it has such a big trade surplus and currency reserves. That would make its goods more expensive and cut the trade surplus. But China's economic growth is highly dependent on exports and investment, with relatively little coming from domestic consumption.

So the Chinese government wants to keep the value of its currency, the yuan, fixed at a rate tied to the US dollar (with a 3% variation allowed). This helps boost foreign investment but makes it more difficult to control inflation. In the long term, China wants to switch the emphasis in its economy to domestic demand. But that will take time - and in the meanwhile the currency reserves could double to reach $2 trillion in a few more years.

[A]Some economists argue that the pattern actually benefits both the US and China. The US gets a cheap and stable source of funding for its trade deficit, allowing the economy to continue to grow as consumers purchase cheap foreign goods - whose low prices keep inflation in check. And China is able to maintain its export-led economic growth, generating jobs for its growing urban population, while continuing to attract foreign investment.

[B]But others argue that it may not be sustainable - and the attempt to unwind these huge imbalances could destabilise the world economy. Brad Setser believes that unless China rapidly revalues its currency, it will face increased pressures on its domestic economy - with over-investment (now approaching 50% of GDP) eventually collapsing, putting pressure on the banking system.

Fred Bergsten of the Institute of International Economics argues that the problems of adjustment - and the huge trade imbalance - will generate growing protectionist pressures in the US and Europe, undermining support for free trade. The IMF and the OECD also see this adjustment as the central problem of the world economy.

And unless it is tackled, the prospects for future world economic growth might well be derailed."
Source: http://news.bbc.co.uk/2/hi/business/6106280.stm


I couldn't had worded my thoughts on the economic situation any better, and sadly I am far more convinced that scenario [B] is more likely to occur. As the U.S. Dollar tanks so does the pegged Chinese RMB exascerbating inflation concerns

I can't even begin to express how poor the lending standards likely are in China, and the international relationship between both nations is "fascinating." As bad as the current sub-prime meltdown in the U.S. is, the lending & borrowing practices in mainland China seem reminscent of 1980's Japan and have likely been worse. Both nations have been financing each others activities with bad debt. In 2006, it was estimated that the Bank of China held over $900B in NPL(non-performing loans) greater than their currency reserves. The ratio of NPL's has lessened in recent years due to increased foreign investments, lending and loan repurchases (good money chasing after bad). The actual amount of NPLs is likely to accelerate in coming years.

    If the Bank of China choses to raise interest rates to combat inflation it will make existing loans more difficult to repay, make exports more expensive, impairing their export-based economy and thus likely increasing the amount of NPL's among businesses(this is the likely scenario). On the other hand, if the Bank of China choses to leave interest rates unchanged this would eventually lead to historically high inflation rates and would undermine their goal of domestic growth. 

 




[1]* Sources:
http://www.ft.com/cms/s/0/337447e4-da70-11da-aa09-0000779e2340.html
http://seekingalpha.com/article/65851-chinese-banks-non-performing-loans-rising
http://www.theaustralian.news.com.au/story/0,20867,19067992-36375,00.html

 

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