One of the biggest myths about China is that its huge FX reserves (around US$2.65 trillion at last count) are a sign of strength. They are not. The reserves are a product of a mercantilist policy that is now starting to backfire.

More to the point, these FX reserves are a product of unsound monetary policy from both the US and China. The US, as owner of the world’s reserve currency, prints money at will. It avoids discipline because countries like China buy up these dollars to maintain export competitiveness.

Ben Bernanke, of all people, highlighted the unsound nature of the global financial system in a speech last week in Frankfurt. In a moment of extraordinary hypocrisy, he pointed out the financial system was no longer working property.

It’s actually been working pretty much the same way for decades, but the US is no longer benefitting from it as they once were. The system has allowed the US to spend way beyond its means since 1971. Now, the spending spree is over and they want to change the system.

China is not so keen. Which brings me back to why China’s mercantilist policy of building FX reserves is a long-term weakness, not a strength.

Here’s how it works. China’s reserve accumulation is a product of it buying US dollars in order to keep the yuan from appreciating. It buys US dollars with newly created yuan, which end up as reserves in the Chinese banking system.

The US’ ultra loose monetary policy over the past few years has seen China step up its efforts to stop the yuan from appreciating. The result has been an explosion in the money supply, credit growth, and now, predictably, inflation.

Inflation in China is a big concern for the communists. As Keynes said, ‘there is no subtler, no surer means of overturning the existing basis of society than to debauch the currency’. Currency debauchment = inflation.

US monetary policy is fuelling inflation in China (probably deliberately so) but with all-up unemployment of nearly 17% in the States, they don’t care. Bernanke said as much his Frankfurt speech last week.

The US is becoming more aggressive towards China because it knows it’s in a position of power.

China may have a massive ‘war-chest’ of US treasuries but it’s hardly a weapon or a threat to the US. The hoard is too big to sell. And if they did it would force a contraction in domestic credit. Not exactly what you want when trying to contain a massive property bubble.

So China is stuck with the prospect of destabilising inflation unless something is done to reign it in, and quickly.

They have two choices, none of which are good.

One, let the yuan appreciate. This would be good for households (as it would improve their purchasing power) but bad for the all important export sector. Many of China’s manufacturers operate on very thin margins. A stronger yuan would wipe out this thin profit layer.

Two. Raise interest rates. This is the likely scenario but also probably the most dangerous. Raise rates too slowly or not enough and inflation continues to build. Increase rates too fast and its property bubble will collapse.

Either way, China has little option but to take liquidity out of the market. The implications for Australia are huge. It means our terms of trade have probably peaked, that interest rates won’t go as high as expected, and that unemployment could rise more than forecast.
If you have faith in central planning and think the Chinese bureaucrats are smart enough to engineer a goldilocks slowdown, then you have nothing to worry about. This seems to be the consensus view.
Greg Canavan For The Daily Reckoning Australia

But if you think that central planning is a ‘fatal conceit’, which history has proven to be the case time and again, then you should be very worried indeed.