[This headline is a little more alarmist than the article. Depending on timing, this delay mechanism could turn out to be a good thing, delaying the deflationary shock to China until it could bear the full weight of adjustment the US needs. Although of course it also go the other way; the delay could makes things worse.]
[But what's interesting to me is that this way of conceiving the process suggests both the mechanism by which US current account adjustment is being put off and a time limit to it. It suggests that it was possible to put off US current account adjustment for as long as China and Japan were in deflation. Now China at least has reached the point where it's not. When it reaches a reasonable inflation rate, it will stop propping up its currency by buying US bonds and accept appreciation, and the US current account deficit rachet down a major notch. And a similar time delay mechanism would operate vis a vis Japan. The European component has already kicked in, but is a lesser contributor to adjustment because of the lesser trade.] Financial Times; Jul 31, 2003 COMMENT: The Fed is in a dangerous game with China By Chen Zhao The Federal Reserve is taking no half measures in its efforts to stimulate economic recovery in the US. To ward off the spectre of deflation, it is prepared to generate inflation and reflate the asset bubble. China is a silent but active partner in the Fed's pump-priming. It would not be possible for US Treasury bond yields to be at current levels were China not a willing and able supplier of savings to the US. Combined annual purchases of Treasury securities from China and Hong Kong have reached $290bn - more than those by any other creditor nation. Both China and the US are having fun at this game. The flow of Chinese savings has enabled Americans to borrow more and spend more. Long- term bond yields are still very low, in spite of the recent bond market shake-out. The refinancing boom continues. The collapse in borrowing costs is reviving capital spending. China is glad to see Americans going on another shopping spree. Its factories are cranking up production at an unprecedented pace and capacity is tightening. China's exports to the US jumped 35 per cent in the first quarter compared with the first quarter of last year and the trend is accelerating. The US's bilateral trade deficit with China has reached $110bn, bigger than with any other country. In effect, China is trading goods for US paper. The rapid accumulation of Chinese reserves means the Chinese are buying dollars to keep their own currency steady. This has allowed US interest rates to remain low, which in turn has encouraged American consumers to buy more Chinese goods. This game of "trading goods for paper" creates a hyper-stimulative environment for both countries' economies - which authorities on both sides of the Pacific want. The Chinese and US currencies are falling against the euro, money supply in both economies is going up and interest rates are low. All of these are powerful stimulants for economic growth and share prices. So far there are no signs that the Chinese are about to change course. Despite intensifying calls to revalue the currency, the authorities recently increased the value added tax rebate for exporters. The rebate amounts to a de facto devaluation aimed at providing pre-emptive protection against a growing number of anti-dumping investigations of Chinese exports. This action suggests that it is naive to think the central bank will soon allow the currency to float upwards. Nevertheless, trading goods for paper works only up to a point. While the game serves the purposes of Chinese and US policymakers alike, it also creates enormous economic and financial distortions that are both self-limiting and self-defeating. With a collapse in interest rates fuelling consumer spending, it is conceivable that the US current account deficit will explode upwards. There is no magic number the current account deficit must reach to signal an impending crisis - but there has never been a nation that has been able to increase its reliance on foreign savings without eventually hitting a brick wall. In the meantime, China will accumulate inflationary pressure. Its economy has been booming for some time and foreign exchange intervention has further fuelled money and credit expansion. China has already climbed out of deflation, with its consumer price index rising at an annualised rate of 1 per cent. Granted, this is a very low inflation rate. Still, with soaring money supply, surging exports, expanding reserves, strengthening consumer spending and fast growth in property investment, inflation will keep rising. When will the party come to an end? When the Chinese have had enough. That will happen when inflation in China approaches 3-4 per cent - which it could do within the next six months or so. At that point, the central bank will be forced to revalue the currency. Another potentially vicious shakeout in Treasury prices could be the biggest implication of such a move. Revaluation would be deflationary for China but inflationary for the US. Whether the Chinese economy could withstand a higher exchange rate remains to be seen. But revaluation would definitely help the Fed achieve higher inflation. A further surge in bond yields could mark the start of the long-foreseen demise of US consumer spending and damage the US economy. This will probably be the moment when investors find out whether the game is a boon for the world economy, or a bane that merely defers another recession and bear market in stocks. The writer is chief emerging markets strategist at Bank Credit Analyst Research Group