I argue here that critics of China’s recent currency depreciation are missing the big picture. First, depreciation is a desperate measure which is a sign of the coming implosion of the Chinese economic model. Second, depreciation is a double-edged sword for China, because the Chinese export machine is heavily dependent on imported components that will rise in prices with depreciation. Third, the ultimate effect of a China economic implosion will be to send US interest rates and inflation soaring. Fourth, on the positive side, there may be an opportunity to rebuild the US manufacturing sector, if China’s economy is in turmoil. Fifth, the political implication is that presidential and other candidates should not expect a stable economy going into 2016, and a ‘crisis’ message may be needed.
China has been experiencing a massive debt bubble, with Bloomberg reporting that “outstanding loans for companies and households stood at a record 207 percent of gross domestic product at the end of June, up from 125 percent in 2008.” The stock market has plunged, construction is slowing, and consumer spending is weak.
So what happens next? We’ve never seen a situation like China before, when a country that is a massive exporter of goods and lending gets into trouble. Most economists, if they have put any thought into a Chinese economic collapse, believe that the government will deflate the currency and ramp up exports to get out of trouble.
But that simply misses the nature of the Chinese economy. In recent years China has been a massive machine for importing components in other countries, assembling them in China, and shipping them abroad. According to the OECD, roughly one-third of the value of Chinese exports consists of “foreign value-added,” meaning imported components and the like. Depreciation can only help so much, since a weaker currency will also increase the cost of the components, even as it makes exports less pricey. What’s more, as the financial system implodes, it will become harder for Chinese companies to get the financing to import the needed components, or to pay back loans for their factories. Moreover, facing a higher unemployment and a restive population, the Chinese government may have to let wages rise even more, reducing China’s competitiveness and boosting the cost of Chinese exports to foreigners.
What does this mean for the US? China will have to start liquidating some of its mammoth foreign exchange reserves to deal with the crisis, including handling bad debt and importing consumer goods from the rest of the world. And if the Chinese government starts selling US Treasures in large quantities, rather than buying, that will mean upward pressure on interest rates.
More important will be the effect on inflation. Arguably the flood of cheap exports coming out of China has been the single most important force holding down the US inflation rate. Chinese-made goods have dropped in price in recent years, while US made consumer goods (excepting food and energy) have risen in price at the producer level. If the China export machine stalls or rises in price, we could see a spike in inflation in the US. Rising interest rates and inflation could be bad news for the US economy.
The positive news, from the US point of view, is that this may provide an opportunity to do some rebuilding of the US manufacturing sector. As Chinese supply proves unreliable, companies may be more likely to look at home.
And what about the US presidential campaign? Rather than issues like wages and inequality, candidates may find themselves facing a rerun of the 1980 campaign, when inflation and interest rates were the key problems. Candidates need to develop a ‘crisis’ message ahead of time, because events may be quick moving.