Whither China's Vassal State

2010 will be a year of major transformations, punctuated by the following key escalating divergence: i) on one hand, the ongoing contraction of the US consumer will accelerate, because even as the stock market ramps ever higher (and on ever decreasing trade volume a 2,000 level on the S&P while completely incredulous, is attainable, but will benefit only a select few insiders who continue selling their stock at ridiculous valuations), household wealth will at best stagnate (as a reminder, an increase in interest rates "withdraws" much more household net worth, due to implied house price reduction, than any comparable boost to the S&P can offset), ii) on the other hand, China, which is faced with the ticking timebomb of continuing the status quo and hoping that US consumers can keep growing the global economy, or alternatively, looking inward at its own consumer class, and shifting away from its historical export-led model. The one unavoidable side effect of this prominent departure would be a renminbi appreciation, and a logical drop in the US currency, once the US-China peg if lifted (a theme opposed recently by SocGen's Albert Edwards, who sees the inverse as likely occurring). The main question for 2010 and beyond is whether this will be a gradual decline or a disorderly drop. And behind the scenes of all the bickering, jawboning and posturing, this is precisely what high level officials from both the US and China are currently negotiating. This will be one of the major themes that defines the next decade. Another phrase to describe this process is the gradual drift of US into a nation that is aware it is no longer the primary economic dynamo of global growth as China eagerly steps in to fill that spot.

Looking at the aftermath of the financial crisis, the two major consequences that will define US economic trends for an extended period of time, are the increasingly more frugal US consumer, whose savings rate is likely to increase gradually to the long-term low double digit average, and an ongoing outflow from equities into safer assets such as municipals, bonds and loans, as the maturing baby-boomers finds the volatility of the engineered equity market far too risky as they enter retirement age.

So with US consumption-led growth entering its twilight days, courtesy of assets that simply do not provide the kinds of returns that allowed for a savings-free lifestyle, what does this mean for Asia, and China in particular? Bank of America provides a good and succinct overview of the major historical themes that have defined Asian economics, and what the next decade will likely bring.

The essence of the Asian development strategy is to build manufacturing capacity for global demand. High savings rates allowed the needed investment in plants and infrastructure to be financed domestically. This strategy was pioneered by Japan in the 1950s and 60s, copied by the Asian “Tigers” (Hong Kong, Korea, Singapore, and Taiwan) in the 70s and 80s, and by a host of other Asian countries in the 80s and 90s. What changed the game was China’s adoption of the same strategy. Exports have increased nearly sixfold since China joined the World Trade Organization (WTO) in 2001. This had a profound impact on the global economy – but it had an even more profound impact on the China’s own economy and labor market. We estimate that 150 million Chinese workers joined the global labor force and began producing internationally traded goods. (As a contrast, the US labor force is 154 million people.)


The integration of China’s vast workforce into the global economy is what tipped the balance. The transfer of jobs and production from the US, where personal and corporate savings rates were low, to China, where savings rates were high, gave rise to huge imbalances. Within a few years after WTO entry, China’s current account surplus became the world’s largest, mirrored by an even larger US deficit.




Currency appreciation would have reduced wages, profits, and the flow of savings, but China was unwilling to allow market forces to play out. Thus, thePBoC (China’s central bank)  intervened in unprecedented amounts, and the vast flow of Chinese savings was channeled  abroad in the form of foreign exchange reserves – mostly short-duration government debt and bank deposits. Essentially, China was financing its own exports by purchasing short-term debt. The bulk ofthat found its way into US markets, keeping interest rates low and setting the stage for the housing bubble.

And herein lies the rub:

The financial crisis delivered a clear verdict, in our view, on the limits to the Asian growth model. It no longer makes sense to pursue double-digit growth by lending cheaply to the US consumer.


Yet change would require less reserve accumulation or – put another way – allowing the currency to appreciate against the US dollar, to which it is now effectively pegged. China needs to manage this “exit” carefully. Moving too fast risks a dollar crisis, with a disorderly drop in the US dollar and a spike in US bond yields. Moving too slow risks a boom-bust cycle in China, with capital inflows and strong monetary growth rates putting upward pressure on asset prices and inflation.

As noted earlier, the transitioning from the status quo, which worked for many years, but is now no longer relevant for the PBoC, will be likely even more critical than Bernanke's decision on when to finally begin raising rates. Because while the latter is mostly concerned with asset-price inflation (and stoking it every chance he gets), the Chinese decision will determine not only interest-rate policy for the US for decades to come, but will decide how soon the US should prepare to accept the consolation prize of first runner up in the global economic leader category. While on an absolute basis the US Economy is still a clear outlier, the rate of growth exhibited by China makes it a virtual guarantee that the days for US economic hegemony are numbered (even more so with GDP determination which is whatever the Central Committee says it is). The only open question is when will China decide it is finally time to shift away from the export-led growth model to one which prefers its own consumers as the source of growth. This transition will likely be of historical importance: just as the inception of the US vassal relationship with China lead to a historic and unprecedented boom in household net worth, doubling to $60 trillion in the span of a decade, so shall the unwind have a comparable impact to the downside.

It is merely this moment that Bernanke and the administration are doing all they can to prolong as much as possible. Alas it may be too late, as China seems to have finally realized that in the global prisoner's dilemma game, it has taken the constant US defections for far too long enough. And with the benefits of perpetuating the charade at this point outweighed by the detriments, 2010 could just be the year when China decides it has had enough.

For much more observations on the US-China relationship, and what lies in store for both the dollar and the renminbi, below is the most recent China FX roadmap analysis from BofA.