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[Insider]

For those born since the industrial revolution (let’s say) “fundamental disequilibrium” is old-talk (from the Bretton Woods agreement) for the condition under fixed exchange rates that justifies/requires revaluation of a country’s exchange rate. What is going on in China is more extreme than that. The entire balance of the country’s economic policy is a crash course … the problem being to decide with what? The US and Europe, for example?
Thursday’s announcement of an 11.9% real GDP gain in Q2 from the year before, after 11.1% in Q1, looks like an honest number (for a change): the nominal GDP increase was 16.4% and the difference is reasonably close to the inflation rate. But the key issue remains trade.

China’s trade surplus is exploding. Its current level of $25 billion a month is a $300 billion annual rate — with non-trade items added in, the current surplus in Q2 was in the region of a $350 billion annual rate. Not bad, considering it was $240 billion in 2006, $160 billion in 2005, and minor until 2004. This explosion shows no sign of letting up, as the growth of exports far exceeds that of imports, and is now working off a much higher base.

China has settled into a pattern of nearly-30% exports growth, versus imports rising 20% or less. But its exports are now running at $1.2 trillion, about the same as Germany’s (as is GDP — Thursday’s boast in the People’s Daily) less than two years after overtaking Britain and France. These exports are also a massive 40% of GDP, extremely unusual for such a huge country, which should have a much larger relative internal market than medium-sizers like Germany, etc. (This statistic alone indicates the degree of distorted mercantilism in Chinese policy.) When 40% of GDP grows at nearly 30%, the growth contribution is nearly 12%. When the 30% that is imports grows at 20%, the growth deduction is 6%. The difference, the net export contribution, is 5-6 percentage points. In a country with a 10% growth trend that only leaves 4-5% for domestic demand if GDP is to grow at trend.

But income growth is in line with GDP. So for domestic demand to grow only 4-5%, versus income at 10%, the savings rate has to go up. But it is already a totally unprecedented 50% of GDP! Fundamental disequilibrium indeed! Alternatively — and back to the real world — export workers may do the right thing by the rest of us, and go out and spend their well earned wages. In that case domestic demand grows faster, and the economy overheats.

The latter is what is happening. Thursday’s wave of releases showed retail sales up 15-16% in each of the Q2 months. Deducting the contribution of net exports from the 16.4% nominal GDP growth rate in Q2, we can deduce that nominal domestic demand was up 13.2%. With an inflation rate averaging 3½% in the quarter, that means real domestic demand was probably up 9% or so. Add in the gain of net exports and you have gross overheating. Lo and behold! While the Q2 average CPI increase was 3.5%, by June it was up 4.4%. This is put down to food prices, but so what? Food prices may be excluded from “core” inflation in the US, but food is certainly a core consumer item in China, as in most of the world. If Chinese export workers get a good piece of the 30% export revenue increase, it is no surprise that they spend a fair part of it eating better.
The problem for the rest of us is that China is now so big. Its exports by themselves are 10% of the world’s (more if intra-Euroland trade is netted out) and an impressive 2½% of world GDP. Their growth at 30% may not be tolerable for much longer under any circumstances, but certainly not if imports can not be somehow induced to rise to match. China needs a 100% revaluation of the yuan to under-4 per dollar. Without that, as long as current gradualist FX policies are combined with the realities on the ground of massive and exploding net trade gains, spending of the resulting flow of domestic income will increase the overheating and lead to soaring inflation. Almost no possible policy tightness can stop this happening. China is due for some violent financial upheavals.

Meanwhile, China is playing a canny game within the constraint of its totally unworkable basic approach. Growth in the US is slowing, growth in Europe is improving. China’s export growth to the US has slowed in the first half of 2007 to (a still vigorous) 18% from 25% a year earlier. To Europe, export growth has jumped from 20% to 35%. Exports to Europe are now as large as exports to the US. So China, with $1¼ trillion of reserves, can use its fire-power to relieve US political pressure by pushing up the euro — as it has been doing, aided by Japanese private investors, who simply “follow the money”. In the two years since the yuan/dollar rate was cut loose, the yuan has appreciated nearly 7% against the dollar, but has actually depreciated more than 4% against the euro.

For now, China can try to stave off the US Congress and Treasury Secretary Paulson by letting the yuan rise a bit faster, retaining its competitiveness by having the euro go up too. But of course this is the means by which the US stagflation will translate into European weakness too. The problem is that China’s grossly aggressive mercantilist policy is likely to be met in kind. A bone-headed protectionist Democratic Congress will be joined by a bone-headed protectionist President of France to undermine the free trade on which all our prosperity depends — but especially that of the primary culprit, China.

Charles Dumas
http://www.lombardstreetresearch.com/

[eminimee]

Did you write that?..If not...could you please let us know what the source was please.

[gorydog]

Did you write that?..If not...could you please let us know what the source was please.

Google says:
the source

GD

[OEXCHAOS]

Folks, attribute articles and link them back when you post them. Frankly, I'm going to assume you have permission if you post more than a modest part of a copy written article under fair use.

Read again if you haven't already. Especially the part about indemnifying Traders-talk if you misbehave.

http://www.traders-t...?act=boardrules

M