Musings on China

My friend has lately been a Chinaman (is that the preferred nomenclature?), in that he is fixated on China's political and economic policies. He suspects that China may have been printing money like crazy, which would explain their massive growth rates and rampant inflation. With price controls, shortages, etc., it looks like all hell could break loose. Not something you want breaking loose in a country with so many men aged 18-35 who can't find wives.

Now I haven't done any formal research here--I did a quick search but everything that looked promising was in some strange language--but it is possible that China is actually in good financial shape. To repeat, I am not making predictions here, I am just saying that the stuff we are seeing from China is consistent with them making good improvements. So:

* In the last ten years (say), China has allowed itself to become more and more capitalist. With a billion people who are still underdeveloped compared to the West and who have been living under actual communism, this is huge. Double digit real growth rates are entirely plausible in this scenario.

* The high price inflation could be due to the Chinese government's suppression of the yuan, rather than irresponsible use of the printing press. I confess I haven't fully worked the mechanism out in my head, but I think you could come up with a general equilibrium model with all your ducks in a row. Here's the intuition: You've got foreigners wanting to buy Chinese exports and invest heavily in the country. Normally that would push the yuan way up; it's impossible to be a net exporter and have a net capital inflow at the same time. (If you prefer, just think that everybody has to trade his or currency for yuan, in order to invest in Chinese assets or buy Chinese products.)

* Suppose the Chinese government just sits back and lets the yuan appreciate rapidly. This would reduce Chinese exports (their goods are more expensive) while it would probably increase investments in China. (Yes the prices of the assets go up, but then you're holding more valuable assets. You wouldn't say, "People buy $100 bonds but not $1000 bonds, because the latter are too expensive!") The appreciating currency amplifies whatever the nominal yield is on the Chinese assets, making them more attractive to investors. At the same time, goods from around the world would become cheaper for Chinese consumers, since the yuan is stronger. The influx of direct foreign investment would allow the Chinese economy to grow even faster, boosting GDP and lowering prices even more.

* Alas, these processes are held in check, because the Chinese government artificially props up the USD vis-a-vis the yuan. I'm not sure exactly how they do this, i.e. I'm not sure if their yuan come from the equivalent of taxes or their earnings from assets or from state-run enterprises or the printing press or what. In any event, the Chinese government takes yuan that it could spend on tanks, roads, or diapers and instead buys US dollars, then US government debt, with them. This keeps the Chinese people poorer than other potential uses of that yuan, and more important keeps foreign imports more expensive than they otherwise would be.

* Because of the high domestic price inflation, the Chinese government foolishly enacts price controls. These cause shortages, as they always do.

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With the riots in Haiti and elsewhere, I hope the Chinese government allows the yuan to appreciate even more than it is already doing. (If you look at a chart of the yuan versus the dollar, you'll see that it hasn't really been "pegged" since mid-2005, or rather that the peg keeps moving.) This would ease domestic price inflation, bring a lot more prosperity to its citizens, and give the government cover to remove the dumb price controls. I'm not sure what the downside politically would be; presumably there are powerful exporting interests that want the yuan weak.

But I don't think you want a billion people rioting over food prices.