China's Economic Dilemma: Nothing Less Than A 10% Revaluation?

If China's economists and leaders are smart, they will need to see whether this idea of restructuring their economy from less investment-based to more consumer-based is viable in the current currency regime of a managed peg.

About 25% of China's GDP is gross exports while another 40% is investment, of which half is estimated to be for the export sector. So this means up to 45% of China's economy is dependent on global demand for her exports. Consumer spending accounts for 25%-30% and even this sector is supported by the strength of the export sector in terms of wages paid by MNC-related factories.

So the geopolitical and macroeconomic question is this: Can China restructure its economy fast enough before the US economy collapses under the weight of a sovereign debt crisis, a budget deficit funding crisis and a health care crisis?

What the US government has done to keep its economy afloat is the same panacea that the Japanese have tried with fiscal stimulus and quantitative easing. But the US can continue to do this by printing loads of electronic money until foreign investors become totally averse to lending their reserves to the US government.

My view is that China will not dump US Treasury bonds until it has a viable exit strategy, which is likely to entail a strong revaluation of the Renminbi.

Global Rebalancing Dynamics Restated

The official talk about rebalancing the economy is just a smokescreen for delaying the currency adjustment that is needed to contain the recycling of capital from China to the US. Given the low purchasing power of the Chinese consumer (adjusted for end domestic demand), a real rebalancing of the Chinese economy can only happen in five to ten years time.

Just look at the dynamics of global rebalancing: China’s consumer spending is US$1.7 trillion out of a nominal GDP of US$5 trillion. In comparison, American consumer spending is US$10 trillion out of a nominal GDP of US$14 trillion. Hence, a 1% decline in US consumer spending over the 2008-2009 period amounts to US$100 billion in contraction of consumer demand.

Assuming that 80% of that demand is imported, this means a potential loss of US$80 billion for the global economy. Over the same 2-year period, China’s consumer spending rose by an average of 12%. This amounts to US$204 billion of domestic demand. If China imports 30% of this demand, then the gain to global economy is an additional US$61.2bil in spending. So netting off US$80billion of foregone US spending against US$61.2 billion of new Chinese spending, there is a net loss of about US$19bil to the global economy. This scenario will change if Chinese consumers import more foreign products for their own use.

Given the reasonable assumption that US consumer spending falls by 10% in the next five years (i.e. 2% per annum), then the loss to the global economy amounts to US$1 trillion. For China to offset this loss, the Chinese have to import an equivalent of US$1 trillion.

Assuming that the base case scenario of Chinese consumer demand growing by 12% per annum and that the share of imported goods/total consumer spending rises to 35% in five years time from 30% currently, then the additional gain in spending for the global economy is about US$516 billion, which is just half of the total losses in global market caused by shrinking demand from the US consumer.

In order for China to be a viable source of global end consumer demand, its consumer spending has to grow by 18% per annum for the next five years and the share of imports to consumption has to rise to 50%. This will result in a net gain of US$423 bill over the five year period or a gross addition of US$1.4 trillion for global economy (before adjusting for the decline in U.S. global consumption).

The latter scenario suggests that Chinese end consumer demand for global goods has to expand by a whopping 30% per annum, or a doubling every two and half years. This can only be achieved by revaluing the Renminbi exchange rate by 10% per annum, resulting in an exchange rate of RMB 4.24 against one US$ by 2014.