Gold has rallied today on the back of positive sentiment in equities which we will be attributing to the year-end effect from now on, unless convincing data on the health of the global economy becomes available over the coming period. In particular, that China`s communicated intention to tighten is not dampening risk sentiment is a sign of over-optimism, unless we assume that market consensus regards the cautious nature of China`s rulers as a sign that the proclaimed tightening phase will be mild and brief. We believe that the outcome in this respect is related to the fate of the USD over the coming months as much as it depends on the domestic Chinese situation, and is a lot more uncertain than it is being factored in by the markets for now.
In any case, the Chinese are out of options, if our analysis of the situation is correct, and although we admit that they are by nature cautious about their decisions, our emphasis is that the nature of the Chinese economy and the political situation at home and abroad does not facilitate the undertaking of radical solutions.
Every one seems to know that China is facing a serious inflation problem at home. Two interrelated causes, among others, cause for this problem, that of hot money inflows, and that of wage pressures as the labor market in the Eastern, coastal regions becomes very tight after years of preferential treatment of the area. It has been reported to be tight for a while, but because Chinese labor has a hard time making its claims heard, serious changes occur slowly. Against this background, the consensus is that the PBOC must raise interest rates to combat inflation, since the yuan is pegged to the USD, but raising rates is ineffective since liquidity extracted by the central bank is more than compensated by foreign inflows that seek to benefit from interest rate differentials. At the same time, if the PBOC does allow the yuan to appreciate significantly against the yuan, the extremely imbalanced, inefficient, government-subsidized, and export-biased nature of the Chinese economy poses a risk of collapse which the authorities are determined to avoid at all costs.
Against this argument it is often proposed that the growth of the Chinese economy is fuelled much more by consumption that it is generally assumed, and that the observed overheating is caused not to a small extent by much needed infrastructure investment in a country that is still a third world economy in many ways. While a higher target of inflation is acceptable for any developing economy, and infrastructure investment makes sense in a long-term point of view, experience shows that bubbles are likely to develop where there are the most convincing arguments to support them. Rationalizations on the basis of size and capacity do not negate the evidence supplied by the parabolae on many of China`s economic indicators.
It is difficult, also, to justify the belief that China needs so many factories of low added-value products, because the country has moved out of the class of nations where such products offer the greatest returns long ago, and remains a profitable destination for their producers only because of the government`s policies that artificially maintain consumer incomes at a low level by investing proceeds in U.S. Treasuries, and other external assets. Indeed, that the government is trying to force domestic firms to invest the country`s wealth oversees, instead of diverting these resources to establish a social security system at home is a sign that the Chinese are beyond their limits in benefiting from savings and investment . Finally, there is the limit posed by physical and natural contraints. The northern regions present such a picture of despair in terms of the quality of the environment that even in the highly unlikely case that the Chinese model, and the people`s tolerance for low wages were not exhausted, it appears that the country itself is very close to its limits.
We must wonder, after all, how much it is the wish of the Chinese to see the income level of the population rise rapidly. It is the explicit desire of the CCP that it will hold on to power for many more years to come (official comments place the lifespan of party autocracy between 25 and 100 years.). Assuming that China is no less susceptible to centrifugal pressures and the desire for freedom than any other country of its size, it is possible that the Chinese government is intentionally pursuing a path that will prevent the income of society from rising too fast in order to prevent the breakdown of social structures that are sustaining the party`s grip on power. After all, one plausible way of managing the excess liquidity in the country`s system without raising wages or interest rates is to impose and increase labor taxes on profitable companies in order to improve the confidence of the general populace. But the Chinese are not choosing this path either because they are worried about competitiveness, or because they don`t want to see the population becoming too complacent about the future, and thinking about here and now, with predictable unpredictability for the domination of the CCP.
What happens in this country will determine the trajectory of the globe for many years to come, and since the U.S. and the rest of the developed world are sidelined to a large extent due to the implosion of the past years, we believe that the future of China is almost identical to the future of the world economy. It is arguable, from a purely analytical point of view, with no thought of the human cost, that a quick disintegration of the Communist Party would bring the easiest transition for everyone. But the CCP is not the Communist Party of the Soviet Union, and in spite of endemic corruption and incompetency, it does enjoy the support and enthusiam of a large section of the population, and can show the rising prestige and wealth of the country, even if it doesn`t imply prosperity, as its accomplishments in defense of its legitimacy. In any case, The Chinese probably do not think much about how much better their fortunes would be if they were ruled by a democratic, more competent and responsible government, since the CCP is all that they have.
In news events, the yields of Chinese CDS have risen last week,on the back of speculation that the country will face difficulties as it tries to bring inflation under control. U.S. sentiment was not impacted by the court decision that struck down a key component of the administration`s health care reform plan, but the development does have long-term significance for the markets in terms of the reelectability of the president. Equities, currencies, gold and oil are rallying, and cautious optimism is the theme of the day for today.
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