China money move: Beijing addresses a glaring weakness

China's currency made it first gains against the dollar Monday because, for the first time in nearly two years, it will no longer be pegged to the greenback.

The appreciation in the Chinese yuan drew cautious optimism from US officials and cheered American manufacturers, who now will be more price-competitive with Chinese factories.

Less visible but equally important, the currency move addresses a glaring long-term weakness in China.

For years, critics of the Chinese economy have pointed out that it is too dependent on exports and government infrastructure spending. The lack of a strong consumer base was China’s Achilles’ heel, they said. By letting the yuan strengthen and, thus, putting more value in the hands of Chinese consumers, the government is beginning to develop that base, which will help stabilize China and insulate it from the ups and downs of international trade.

This shift is a long-term process, however. The recent global recession illustrates how vulnerable China’s economy continues to be. As foreign orders for China’s products evaporated, and lacking a strong domestic market to take up any of the slack, China’s factories were forced to reduce staff levels and cut production.

How did China’s leaders react? Why, in the same manner as other governments around the world – they threw money at the problem. Initially, China committed to spend $586 billion by the end of 2010 to keep the economy moving. However, when accounting for the total amounts injected into the economy through direct infrastructure spending, as well as liquidity made available to the banking system, the actual amount has almost doubled.

Not only did China pour in more government money than America’s $787 billion stimulus package, it invested it in an economy that is less than two-fifths the size of the US economy.

Of course, it’s hard to argue against success, and the latest growth figures from China indicate that the economy continued to expand in April at an annualized rate exceeding 12 percent. Property values also increased again in April – this time by a record 12.8 percent compared to April 2009. This reality has forced the government to admit that speculation is verging on the hysterical.

Recognizing the potential for disaster should the property bubble burst, Chinese authorities have implemented several changes in an attempt to cool the market.

But China’s critics are not asking if China’s market is hot. They wonder why it’s hot?

In other words, how much of China’s reported growth is “real”, and how much can be traced to government spending? If government largesse is indeed responsible for most of China’s growth, then the prospects of China leading the way to a global recovery, as so many are counting upon, could be misguided.

Rather than begin to reduce its stimulus as other nations are now contemplating, China appears to be expanding it. The development of new roadways and massive transportation projects continue at a breakneck pace.

A June 7 article in the Financial Times highlights some of these massive undertakings, the largest of which is a plan to build nearly 30,000 miles of new railway lines by 2020. The price tag for this project alone is expected to exceed half a trillion dollars.

This begs the question: Why, if the economy is indeed growing as advertised, does the government find it necessary to continue to spend so heavily?

The answer is as basic as it gets. China is forced to increase spending in an attempt to bridge the gap arising from declining export sales, says Yu Yongding, economics professor at the Chinese Academy of Social Sciences and former adviser to the Bank of China.

"China's investment-driven and export-led growth pattern is not sustainable,” Professor Yu told a meeting of Australian officials in Melbourne last November. As a former insider, privy to information not readily or freely available to the public, he points to government infrastructure spending, which consistently totals about 50 percent of the country’s gross domestic product, as evidence of a fiscal policy that cannot continue indefinitely.

Before the recession, demand for China’s exports increased year after year, and this helped camouflage the nation’s fundamental shortcomings.

China’s announcement this week that it will end its practice of fixing, or “pegging,” the yuan to the US dollar, sends a clear signal that China recognizes the importance of its own domestic market.

The yuan will almost certainly appreciate in value, which means China’s exports will cost more for foreign customers. This will likely result in weaker international sales for goods produced in China. However, consumer buying power for Chinese consumers will actually strengthen, and should boost demand for consumer goods in what is easily the largest, yet mostly untapped, consumer market on the planet.

This could be exactly what is needed to address the concerns of China’s critics. But it’s a long-term move. While the yuan will no longer move in lock-step with the dollar, it will still be closely tied to a “basket” of currencies, weighted heavily with the dollar and the euro.

China’s rebalancing will take years.

–Scott Boyd is a currency analyst and writer for Oanda, a Forex trading company with offices in New York, Toronto, Singapore, and Dubai. Neither Mr. Boyd nor Oanda take positions in any currencies.