Analysis from AdvisorAnalyst.com

China Holds the Trump Card?

China is trouncing its economic competition when it comes to manufacturing exports. In 2008, China decided to hitch its trailer to the U.S. dollar, fixing its exchange rate at 6.83 yuan. This was a wise move on China's part considering at the time, its export sector got destroyed by the global credit meltdown, and the shipping business all but died, following the bust at Lehman Brothers.

At the same time, China embarked on a bold $586-billion (U.S.) stimulus in the fourth quarter of 2008 to spend its way domestically out of the credit crisis, and loosened bank lending (which added $1.3-trillion in new domestic bank credit). This initiative on its part meant that China was able to stockpile cheaper commodities, buying them ahead of demand, and pump liquidity into its real estate and equity markets, while waiting patiently for its coveted export sector to return to prominence.

Shanghai and Hong Kong property markets have been large beneficiaries of China's easing and spending program, reaching what some analysts deem are "bubble" levels. So far, however, the export sector has recovered, though not commensurately, leading to economic imbalance.

Famed investor Jim Rogers, of Rogers Holdings agrees there is a bubble in Shanghai and Hong Kong property. "Certainly, Shanghai real estate or Hong Kong real estate should decline," said Rogers, 67. "My goodness, if anything's in a bubble in the world, that and U.S. government bonds are certainly very overpriced." Rogers also said that "by no means is China's economy in a bubble."

Li Ka-shing, one of Asia's richest men – or rather, Li's construction company Cheung Kong – insisted there was no such bubble, even though Hong Kong real estate prices saw the biggest increase among top housing markets last year.

With its deflationary oversupply of 10 to 15 million labourers laid off during the crisis and its fixed exchange rate policy with the U.S., China will continue to recover at the expense of all its other emerging market peers in the exports sector.

Some countries have become downright impatient about their own economic interest, and have intervened this week, buying dollars. The Globe and Mail reports that at least four of China's main competitors in Southeast Asia bought dollars Monday, in order to counter China's "beggar thy neighbour" policy, that protects its domestic interests at the expense of others.

It's not likely that China is considerate of its competitors' woes, and as Richard Russell, of The Dow Theory Letters so aptly puts it, "I'm wondering how our leading creditor, China, feels about the crowning of Bernanke." Russell adds, "I can just hear China's premier muttering, 'Never mind the accolades, mind the $1.5 trillion in U.S. dollar-denominated securities that we've accumulated. What are our dollars going to be worth in 2050?'"

This probably means that China will likely diversify some of its reserves into gold, which is good for the yellow stuff in the long term, but it also means that China, in the near term, must continue to lend its support to the dollar in order to support its competitive ambitions and the value of its foreign exchange reserves. In the long run, China must play a meaningful role in the health of the U.S. or face its own destruction. As goes the U.S., so goes China. In this regard, China does indeed hold the trump card.

As long as China remains symbiotically tied to the U.S., its agenda will be to see a moderate amount of reflation in the value of the dollar, though not too much, just enough to feel better about their investment in treasuries.

Having written at length about carry trades over the last month, I add that as the U.S. dollar carry trade helped China escape its export woes at the expense of all others with the doubly cheap yuan tied to the devalued and widely available U.S. dollar, the resumption of the yen denominated carry trade this year will provide a liquidity offset, allowing for return to the kind of economic balance favoured by China, that comes with a stronger dollar.

It's notable too to mention that aside from its past of failed monetary policies, Japan's deflation woes have also had a major contributor – China – to thank. Its ironic that in Japan's economic misfortune, we and China can find economic balance.

On that front, China is not likely to do anything that would reduce its currency advantage while it works at rebuilding its export sector, but it will use other means to carefully cool domestic imbalances by curbing lending and raising interest rates. At this point, China's policy decisions threaten commodity prices as monetary tightening means a reduction in raw material imports, and that is a decision the Chinese can live with as long as its exchange rate policy favours the export sector. A stronger dollar gives China breathing room relative to its issuance of yuan.

For us, it may mean we may have a meaningful opportunity to accumulate assets in the commodity complex and gold, assuming there is a resultant correction or volatility as a reaction to reduced demand from China, for the time being.