Will Chinese Yuan Flee to America Market Safety?

You remember all the hand-wringing about the implications of china’s rapid growth overtaking the US dollar to become the reserve currency of the world?

McKinsey is out with an article by Gordon Orr, their man in Shanghai—well at least until the Chinese read his article in the McKinsey Quarterly—with a provocative list of possibilities for the Chinese economy in 2011.  It makes for good food for thought as you digest President Obama’s state of the union speech about “we do big things here in America” bravado.

SOURCE: HSBC

Mr Orr lists the following problems facing China:

1.      Inflation in food prices will take longer than expected to control. The food supply chain is maxxing out as wealthier Chinese eat more and could lead to further food quality crises. Even small distribution problems can exacerbate supplies and raise prices.

2.      Middle-class bankruptcies will expand dramatically if inflation drives up interest rates and drives down real estate values in a bursting bubble of speculation. Buyers have aggressively bought multiple properties with every penny of free cash flow.  Sound familiar?

3.      Minimum wages will rise, but productivity gains will outstrip labor costs. The government fearing labor unrest will raise minimum wages, Orr says, by 15 to 20 percent.  Complaints about employers not paying overtime or demanding longer hours will likely grow.

4.      Chinese cities could see demonstrations over food price rises, unemployment, or both. The government will quickly try to respond but fears protests will spread to other cities. The combination of food price inflation, the real estate bubble, demands for more worker productivity even with higher wages piles up into public dissatisfaction

5.      China’s economic growth will be lower than expected. To fight inflation subsidies to consumers will be reduced and discretionary spending will fall with it. The cumulative impact could be slower economic growth and all the consequences a cooling economy brings.  The Wall Street Journal reports that China’s economic and market data may be under-reporting its true situation meaning economic growth might actually be higher than China reports but so could inflation which makes the risk of bursting bubbles even higher.

6.       China will accelerate its “invest out” program in the new five-year plan.  Mr. Orr suggests China could easily double its cumulative outbound investment in other countries within the next five years. In so doing China sees diversifying its income potential across markets as a way to reduce its own volatility and put its treasury of reserves to work profitably while expanding its role in other markets to keep exports growing.  Orr predicts this will lead to major problems with some countries resisting China’s attempt to ‘buy the country’s strategic assets’ before its money runs out.

7.       China will try to reduce its ownership role in domestic business. Reducing the government’s stake in Chinese companies will reduce liquidity and ease speculative pressures encouraging a buy and hold strategy for investors wanting a place in the Chinese markets.  Share prices could be expected to fall making China more a buyers’ market for outside investors even while China itself uses the cash to buy foreign companies and assets outside China.

So Let’s Think About This for a Moment.

China’s overheated economy is having trouble managing a soft landing so China might unload assets to foreign investors thus reducing the government’s stake in China’s markets.  There are plenty of risks for foreign direct investment in China but the Chinese government pitch book will say this is your best opportunity to get into the ground floor for China’s next boom—if you survive the looming bust.

Meanwhile, instead of buying US Treasuries China will use its currency reserves and proceeds from asset sales at home to buy up better quality assets around the world to assure its access to strategic markets and acquire the best technologies, resources, expertise and intellectual property to fuel its next boom.  In consolidating, capital starved markets there will be no shortage of sellers.

Back home in China, inflation, housing bubbles, and low wages are making the aspiring middle class angry that the Government is running their economy in the ditch. The government will use both carrots and sticks to keep the lid on and preserve its control fearing domestic unrest more than anything.

This seems a far different story than President Hu Jintao was telling us just last week when he predicted that China’s Yuan will be the world’s reserve currency within twenty years.  But then again, maybe that side trip to Chicago was to check out the price of penthouse apartments on Michigan Avenue after he retires in 2012.

Welcome to America—-we know a lot about short sales!

PS:  Pssst, Hu Jintao have we got a deal for you—ever hear of Fannie Mae and Freddie Mac?

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