Chinese Economic Problems Ahead?

Everybody is talking about how China is eating their lunch. Have you noticed some very serious economic problems are potentially brewing for China as it struggles with a host of problems associated with becoming a developed nation? For one currency issues could undermine China's current economic plan.

A recent Economy.com articles says that the Chinese economy is barreling toward a potentially damaging investment bubble. The government may need to take corrective action soon or it will face the unenviable task of mopping up additional nonperforming assets. Such an event could also jeopardize a smooth liberalization of the financial sector, which is mandated by China’s agreement with the WTO.

Here is an important point. The rapid expansion of manufacturing and the huge amount of FDI inflow are creating difficulties for China. One consequence of the huge inflow of foreign currency into China is that the money supply in China has expanded rapidly. By law, exporters in China must convert their foreign earnings into yuans. In a free capital market, this would have resulted in an appreciation of the yuan. However, since the Chinese government is committed to a yuan pegged at a fixed rate to the U.S. dollar, the government must print more yuans to buy the excess foreign exchange.

Broad money grew by well over 20.7% in September on a year-on-year basis, the ninth consecutive month M2 has risen above the central bank’s target of 18%. Speculators who are converting their foreign currency holdings into yuans in the belief that the government will revalue the yuan sooner rather than later are also fueling the money supply growth.

As a reflection of the rapid expansion in money, outstanding loans by all financial institutions reached over $2 trillion in September, an increase of 23.7% over the same month a year ago. Concerned by the rapid expansion of credit, the People’s Bank of China increased the reserve requirements ratio of all financial institutions except rural and urban credit cooperatives to 7% from 6% beginning in late September, taking an estimated $18 billion out of circulation. To further soak up excess liquidity, the state-owned China Development Bank announced that it will issue $500 million in dollar-denominated bonds. These measures may, however, be too little too late to cool down an economy that is showing clear signs of overheating.

On the currency side it is becoming increasingly evident that the economic costs to China of not adjusting their exchange rate are rising and are already overwhelming the benefits of China's current position. A large one-time appreciation of the yuan and the subsequent adoption of a more flexible exchange rate policy will ultimately occur. This is one to watch for.

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