Analysis from AdvisorAnalyst.com

China, the Countervailing Force

China is the countervailing global economic force, the antithesis of America, its cash-rich economy cantilevered against the weight of its debt-laden counterpart. Whether we believe it or not, China's decisions do affect us, either balancing in our favour or not.

In a decade, China has amassed the bulk of it $2.4-trillion (U.S.) foreign exchange reserve, making it the lead financier of the spendthrift U.S. economy, owing to blockbuster exports growth to consumers seeking cheap manufactured goods.

In 2008, however, the credit crisis hollowed out the export sector as credit, the global shipping business, and consumption froze, and it's growth engine seized. China's reaction was, forcibly, to fix its exchange rate, and subsequently embark on a bold and massive $586-billion spending plan.

In the 16 months since then, China`s gross domestic product growth has recovered (big surprise), its economy is printing 10.7 per cent GDP growth, property prices are said to be in a bubble, and equity share prices in Hong Kong and Shanghai have recovered by 77 per cent and 41 per cent from the March 9, 2010 bottom, respectively (as of January 31, 2010, local currency), though they are down 36 per cent and 50 per cent respectively from their highs.

Asset and food price inflation are issues, and Chinese policymakers have to decide on what to do next to rein excess growth. They have moved to tighten lending and raised reserve requirements. Critics, though, are calling for policymakers to hike the yuan’s exchange rate.

Jim O'Neill, Goldman Sachs' chief economist, told Bloomberg, "I have a strong opinion that they're close to moving the exchange rate," in a telephone interview from London after China's central bank told lenders on Feb. 12 to set aside larger reserves. "Something's brewing. It could happen anytime."

O'Neill's thoughts deserve serious consideration. He does not refer to a floating yuan. Currency traders, on the other hand, are champing at the bit for this.

The Wall Street Journal writes that China policymakers might opt for a gradual approach of allowing a small exchange rate hike first, and then allow the yuan to rise gradually, a familiar option.

Most Chinese economists believe the right solution to tame the surplus and inflation in China are domestic policies that lower the country’s high savings rate.

"To only focus on the exchange rate is the wrong approach. You have to look at fundamentals," said Yao Yang, an economist at the China Center for Economic Research in Beijing. "It will kill China's economy if you appreciate the renminbi by 20% in one month."

After reading these and many other thoughts, my sense is that O'Neill has the right idea in expecting a fixed hike in the exchange rate. China's willingness to interfere with the resurrection of its export sector any time soon is less likely.

My gut tells me time heals all wounds, and if the dollar strengthens moderately during the course of the year, as short dollar positions are covered, the yuan's competitiveness will moderate as well. The dollar/yuan bottomed in November. Following 13 straight months of declines, China's exports grew by 17.7% in December, and 21% in January, year-over-year.

By the way, if the dollar was to strengthen too much, China is in the position to sell it down in order to re-balance things.