China – Time to Get Worry

For now, the global financial markets are taking cues from three key themes. Firstly, sovereign debt problems with the saga surrounding Greece’s finances that has created tremors in the European monetary union. Secondly, China tightening credit given the massive surge of new loans in the first half of January 2010, fearing a bubble burst of its own. Thirdly, Fed’s exit strategy with its move in the discount rate last week, as part of its first active step toward reversing its emergency policies.

This, in turn, is keeping the dollar on solid footing and keeping pressure on European currencies and those currencies that are dependent upon sustained growth and demand from China – the AUD, NZD and BRL. The sentiment shift has taken place when it comes to the recovery prospects for global economies. More worrying is the bigger threat that will likely come from growing trade tensions between China and the rest of the world.

Over the last 14 years, China’s economy has grown a whopping eight-fold to US$4.9 trillion and has quickly ascended to become the world’s third largest economy, which normally among other will be reflected in a much stronger Chinese currency. Over the same period of time, Chinese currency has only strengthened 18% - a mere drop in the bucket. And that is where tensions are threatening to boll over.

On the purchasing power basis, the Chinese currency is 40-50% too cheap to US dollar. Against the Japanese yen, it is 26% undervalued, 37% against Korean Won, 50% against AUD, 27% against Rubble, 12-13% against MYR and SGD, according to IMF estimates. In a lay man explanation, it would cost 12-13% more to import identical goods from Malaysia and Singapore than it would from China.

Consequently, the G-20 has made Chinese currency policy its number one agenda under the code word ‘rebalancing’. As it becomes increasingly evident that China will not play ball on allowing its currency to appreciate to a fair value, one could expect the geopolitical tensions to rise and expect to see two forms of protectionism to follow – trade tariffs and currency devaluations against major currencies, to which the value of the Remenbi is primarily linked.

I continue to think that safety and capital preservation will re-emerge as the prime driver of capital flows around the world towards the US dollar.