China should return more wealth to its people

As G20 finance ministers gather in South Korea today, the central issue is around exchange policies and avoiding the outbreak of a global trade war.

China is under intense pressure from the U.S. and other emerging markets to revalue its currency, which is pegged to the US dollar and widely believed to be undervalued by 20-40%.

China has resisted such pressure by pointing out to potential disruption to its export-led economy and its recent efforts in stimulating domestic consumption. The central bank PBOC has recently raised benchmark interest rates by a quarter point, the first time since the onset of the 2008 financial crisis, despite signs of cooling economic growth. This may be the beginning of a series of interest rate hikes to rein in inflation.

Much of China's recent growth has been fueled by injecting loose credit into the banking system, which may have caused excessive domestic inflation, especially in the property sector.

These are happening in an environment that developed nations are trying to continue or enhance their loose monetary policies in a bid to spur growth, or at least to avoid Janpanese-style deflation.

Recent discussions (e.g. by Li, Dongrong) out of the PBOC make it very clear that Chinese officals are very aware of the international financial environment and the challenge facing China.

Leaving it at the status quo, China may face a greater risk of hot money chasing after higher returns. The flood of easy money, through various channels such as private equity, may contribute to rising asset inflation and consumption-good inflation.

Inflation, while necessary for growth if it's moderate, chips away citizens' purchasing power and helps to increase economic inequality and social unrests.

On the surface, China has become a rich country. Commentators often point to its ballooning exchange reserve (about $2.6 trillions). But much of this money cannot be used to help ordinary citizens; instead it's financing the U.S. government which in turn help to lower the already-low interest rates. In terms of GDP per capita, ordinary Chinese are still quite poor. China should return some of the wealth to its people, by appreciating its currency more and bringing down actual inflation and inflation expectations.

Raising intereat rate and the Yuan may actually go hand-in-hand in a gradual fashion, to power both domestic and international consumption. Higher interest rate puts more moeny in the hands of savers, and a more valuable currency obviously puts more purchasing power to any Yuan holder.

And, a lower inflation gives ordinary people a much needed break in the race to save enough for purchasing an apartment.

American kids are lazy and distracted?

There are real fears that America as a country has lost its touch, and the American as a people have become less competitive and too dependent on government largesee.

We don't really know if that's true. But there is that fear. In this new survey about American Dream, the middle class is in general still optimistic about the future and the access to opportunities. What's shocking to me though, is this:

Nearly half (49%) thought that countries like China and India are so far ahead of America that the United States won’t be able to catch up.

I think that's largely a reflection of economic growth rates. I doubt this impression is created by comparing per capita consumption or production.

What about the next generation and education?

Here it is very interesting to note a discussion by the CEO of the privately held SAS Institute:

His discussion about education in America was the most disconcerting. American students are not entering the fields of science, engineering, statistics, and math. These are the areas that would help America grow, invent and discover. He thinks American kids are too distracted by Twitter, Facebook, the Internet, Playstation, TV, iPhones, iPads and cell phones to do the hard work that is required in these fields. We have become a lazy distracted society. Our best colleges are educating foreign students who take that knowledge to their own countries.

There is a lot of truth in this observation. But this type of distraction has always been there, although the new technology has made it more pervaisive and compelling.

I remember growing up in China back in the late 70s and early 80s, the biggest distraction from school work was Kungfu novels and movies. Kids could spend all day reading and watching them for entertainment and excitment. The way to deal with the distraction is the same: keep a great distance and have great control over time. It's a struggle, as it has always been.

How do kids spend their time is an investment problem. Ideally we want them entertained, but we also want them to focus more on the production side rather than the consumption side.

When watching video games, for instance, I would like my kids to think about how to make these games instead of just playing them. I believe it makes a crucial difference.

High inflation, low inflation

China's central bank just announced a surprise increase of interest rates to help rein in the inflationary pressure.

It said it was raising benchmark rates by 25 basis points, taking one-year deposit rates to 2.5 percent and one-year lending rates to 5.56 percent.

Consumer-price inflation has already crossed above Beijing's 3% target for 2010. In August, the annualized rate was 3.5%.

Over here in the U.S., the opposite has been the case. The core consumer inflation rate is hovering around 1%, and maybe heading lower. In the face of slow growth, deleveraging, and high unemployment rate, this is alarming. Because the economy may be headed for deflation, when prices for goods and services are trending lower in general.

In other words, the economy is too "cold" in the U.S. and too "hot" in China. And higher interest rates in China may serve to attract even more hot money. On the other hand, the Fed's easy money policy would potentially add more liquidity to the world economy, much of which would find its way into China's asset markets, causing more inflationary pressure.

China has so far been quite successful in controlling credit expansion and contraction using adminstrative means, in order to maintain its currency peg to the US dollar. It's perhaps time to change that practice to help balance the world economy. A stronger yuan can help China take on more leadership role.

How can QE help the economy?

The Federal Reserve chairman Ben Benanke's latest speech has made it clear that both the current high unemployment rate around 10% and low inflation rate are inconsistent with the Fed's dual mandate. Therefore further action is appropriate.

Another round of "quantitative easing" (QE) is now widely expected by the market. How much and exactly in what form remain to be seen.

Has QE been successful? How does it help create jobs? Why do we need more large-scale asset purchase by the central bank? Should the Fed be even more aggressive?

Here is an old paper by Joseph Gagnon at the Peterson Institute for International Economics that helps answer some of these timely questions.

QE and global liquidity probblem

The sluggish recovery in the U.S. economy is prompting the Fed to refocus on "quantitative easing" (i.e., buying more long-maturity securities to lower the borrowing costs). That may serve to flood the financial system with even more liquidity. Professor Joseph Stiglitz talks about the potential consequences:




The Fed’s move towards more quantitative easing, conveyed in its recent policy statement issued in September, follows Japanese intervention to weaken the yen and Swiss National Bank actions aimed at its currency.

Increasing exports by weakening the dollar is one channel by which the easing could boost the US economy. But it is impossible for every country to weaken its currency and export its way to higher growth at the same time. So we're looking at the competitive devaluation scenario of global currencies. This is one of the most strong supports for gold prices. More QE would mean even higher gold prices, unless we enter into another recession.

The Fed is facing another major conundrum, not unlike the one faced by Mr. Greenspan back in 2005. Back then, the global "savings glut" was seeking outlets in the U.S., pushing the yields ever lower for the long-term assets. The liquidity found its way to private equities and the real estate market, which led to the financial meltdown of 2007-2009.

The money supply has never gone away. And the Fed is adding to it.

More easing may do very little as the rates are already very low and there aren't many credit-worthy borrowers. On the other hand, there isn't any other option for the Fed to counter deflation risk in the face of high unemployment and consumer deleveraging.

The economy is sick, and drinking more liquid may not help.