China: Opportunity Or Threat

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The recent visit to the United States by Chinese President Hu Jintao got a lot of attention and coverage in international media and the fact that so many important people showed up for this meeting shows how important it was for both sides.

For China, this visit was important not only for political reasons, but also for building its prestige on the global stage. From an economic point of view they are able to act from a position of strength.

Hu said a few days before the visit that, “the Dollar dominated currency system is a product of the past.” He also said that the Chinese yuan is not yet ready to take over as the new world reserve currency. It remains to be seen what “not yet ready” means according to the Chinese definition, but we think China will make a number of very significant changes in coming years that could have a lot of consequences for the West.

The strategy of China for the last 30 years has been to keep its currency artificially low in order to promote exports and the country has been extremely successful in doing so. However, this has resulted in significant imbalances in the world economy that sooner or later need to be reversed. China has been accumulating huge amounts of foreign currency reserves and a lot of it was reinvested to buy U.S. Treasuries, therefore financing “America Inc.” and other countries which are now running large deficits.

Let’s be clear, China has a number of very serious problems, different problems than Europe or the United States, but equally challenging. The growing imbalance between the booming cities and rural areas continues to drive more and more people to the big cities. This growing imbalance is increasing socioeconomic tensions and, coupled with strong inflationary pressure, makes it increasingly difficult for people to make a living, especially in more rural underdeveloped areas.

There is also a large infrastructure and pollution problem in China and these problems need to be solved in coming years. The key advantage that China has is that it is not a democratic system and that the ruling party can make and implement much needed changes quicker than most other countries. That should help China to continue to grow their economy and keep adding jobs for many millions of people.

I think we are at a very important turning point in the history of China. For the past few decades the focus was on producing and exporting goods, and at least in that context, China has been very successful. Going forward, China needs to focus more on securing a stable supply of energy, commodities and technology and therefore its interests are not so heavily biased towards keeping a strong currency anymore.

Imports are growing faster than exports, currently at a rate of about 25 percent, compared to export growth of only about 17 percent. The overall trade surplus of China has fallen about 9 percent from the previous year and about 34 percent from 2009.

There is another factor that needs to be considered. China needs to deal with its inflation problem and we think it will tackle it from two sides. They will continue to hike interest rates further and therefore control domestic growth and prevent the economy from overheating. At the same time, they will change their currency policy by allowing Chinese companies to hold large foreign currency balances abroad and use them for investment purposes. That will help the Chinese central bank because it is no longer forced to buy foreign currency reserves and issue cheap domestic currency, which had in turn caused further inflationary pressure in the past.

I think that this will help the Chinese central bank to bring inflation under control and will probably allow them to keep further interest hikes moderate and diminish the risk of them over-tightening, which should also be positive for Chinese stock prices. So even a small, controlled appreciation of its currency will help them eventually to bring growth and inflation at home under control.

That’s why we think that China will let their currency appreciate. But, as always, they will do it when it serves their purpose, and that might now be sooner rather than later.

At the same time, the effects from such developments would be negative for the West. In a time when Western governments are so dependent on countries like China to buy their debt, we expect the purchase of government paper to decrease in coming years, which will make it a lot harder and more costly for troubled governments to issue debt. This will eventually lead to higher interest rates in the West, and that would come at a time when inflation is already on the rise because of rising commodity and energy prices.

Central banks in the West will probably try to keep short-term rates low for as long as possible in order to stimulate their domestic economies. But the longer-end of the yield curve could experience a significant increase in yields. We feel that adding further exposure to Chinese yuan and possibly other Asian currencies is the right thing to do going forward, and also caution investors to hold bonds with long maturities.

–Daniel Zurbrügg, CFA

Daniel Zurbrügg

is the Managing Partner of Alpine Atlantic Global Asset Management, a Swiss-based independent investment management firm. The firm provides clients with independent investment management, asset protection and family office services and is the issuer of the global investment newsletter Echo From The Alps. With a global network of partners, Alpine Atlantic's aim is to provide clients with true "turnkey" solutions for global investing. Prior to setting up Alpine Atlantic, Daniel held various positions with other banks and financial companies. Daniel is a Chartered Financial Analyst and regular guest speaker at international investment conferences.

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