Underlying Risks to China (and its Trading Partners) Still Growing

We've been arguing that (1) the Developing Markets' "inflation beast keeps growling" (click and scroll down) due to structural problems such as oil prices and governments' trade and regulatory policies, (2) Chinese equities' still have an adverse risk/reward ratio, and that (3) we probably won't go overweight equities until we see contagion from the U.S. & European financial crisis result in real crisis in some of the Developing Markets (noted throughout this section).

A post from Michael Pettis in "China Financial Markets" supports our overall caution quite strongly. He continues to see the Chinese yuan on a freight train higher (which will increasingly destabilize global inflation, trade, and demand trends) -- and he sees decreasing chances of anyone stopping it. The consequence of a painful revaluation of the yuan would be another major "leg" to the global financial/economic contagion:

• Speaking about exports, I am increasingly concerned that the trade surplus in China is actually beginning to decline, and much faster than people think. My reasoning is simple and completely intuitive – i.e. there is not a shred of hard evidence to back it up – but I nonetheless think it highly plausible. I contributed the following (somewhat edited) comment to today’s discussion on Chinese reserves on Brad Setser’s blog (http://www.rgemonitor.com/blog/setser):
  

• “Given the rapid increase in various proxies for hot money inflow, it is probably pretty safe to assume that hot money disguised as FDI [foreign direct investment] and/or trade is also growing quickly. Certainly the nearly 70% growth in FDI during the first quarter suggests that there has been an increase in speculative inflows disguised as FDI. After all there was no very good fundamental reason for this growth – in fact it is not hard to argue that FDI in China is less, not more attractive today than in the past few years. If this is true and a big chunk of FDI is simply hot money, it is probably also plausible to argue that hot money disguised as trade has also increased significantly.”
  

• “From that it follows that export growth and the trade surplus have probably declined much faster than the small decline in headline numbers suggest. If true, this complicates matters. Thanks to deteriorating global conditions China may actually already be running a narrow trade surplus or even a small trade deficit, which could make the authorities all the more afraid of a maxi-revaluation [a deliberate, sharp strengthening of the Chinese currency, to ward of speculation/"hot money" that it will continue to rise], and yet for the reasons we have been discussing over the past fifteen months the maxi-revaluation is probably inevitable because of the crazy monetary consequences of hot money inflow. The cost of a maxi-revaluation may be rising even as the cost of steady appreciation is. The longer they wait the worse the options become.”
  

• In other words, if we are starting to see Chinese monetary growth powered exclusively by hot money inflows, instead of by the trade surplus as it was in the past, we are entering into a far more volatile stage of the game, where the consequence of a policy misjudgment may be higher than it has been in the past because the outcome is likely to be much more heavily determined by very volatile and hard-to-control and hard-to-judge hot money flows. The risk associated with an adjustment is rising, in other words, even as the cost of not adjusting is too. I worry that another quarter or two of $200 billion plus increases in reserves is going to make the adjustment process for China much more difficult. It is increasingly important that the recession in Europe and the US be as brief as possible if China is going to have room to adjust. If we see additional weakness in the global environment, I think China’s room for maneuvering declines substantially.