China Pursuing a 'Beggar Thy Neighbor' Policy Amidst Financial Crisis

Lou Jiwei, the chairman and chief executive of the $200 billion China Investment Corporation (CIC), said China had no intention of "saving" the West from the financial crisis because he “does not have the courage,” to make additional investments in U.S. financial firms

The CIC, China’s second-largest Sovereign Wealth Fund (SWF) after the $311 billion State Administration of Foreign Exchange (SAFE) fund, is responsible for managing part of China's foreign exchange reserves. It is modeled similar to Singapore's Temasek Holdings.

The IMF recently estimated China’s reserves will top $2 trillion at the end of 2008, and expects the total to swell between $700 billion and $900 billion in 2009 despite the slowing global economy.

"Right now we do not have the courage to invest in financial institutions because we do not know what problems they may have," said Mr. Lou, at the Clinton Global Initiative conference in Hong Kong.

Mr. Lou invested $3 billion into private equity firm Blackstone (BX) at $29.60 a share in June 2007. The share price of the fund closed yesterday at $5.73, resulting in a near 80% loss of $2.4 billion. The fund has had similarly bad results with investments in Morgan Stanley (MS) and Barclays (BCS).

He added that the uncertainty created by the rapid pace of changes made in the West also gave him cause for concern. "The policies of the developed nations on these financial institutions are not clear. Until they are clear, I don't dare to invest in them. What if they go bust? I will lose everything," he said.

He also underlined China's determination to look elsewhere for its investments. "We don't want to look at only the advanced or developing countries, we also want to look at emerging markets."

China has also put together a $250 billion bail-out package for its domestic economy and will ramp up spending on public infrastructure projects in order to boost internal consumption.

"China can only save herself because the scale of China is still rather small," he said, adding that China's economy is not yet strong enough to have a significant effect on the global economy. "If China can do a good job domestically, that is the best thing it can do for the world," he said.

On the currency side, China has begun to devalue the yuan for the first time in over a decade. The yuan depreciated after the central bank shifted the central peg of its dollar band twice this week in an effort to boost flagging exports. The move came after the yuan had appreciated about 20% in the three years to July 2008. President Hu Jintao warned earlier this week in a speech to the Politburo that China is "losing competitive edge in the world market".

The effort to devalue the yuan came after China’s foreign currency reserves increased a record $35 billion in October.

Outgoing US Treasury Secretary Hank Paulson is viewed as a "friend of China” but President-elect Barack Obama called China a "currency manipulator" during the campaign, a term that carries penalties under US trade law. A move to devalue the yuan could set off a conflict with the incoming administration.

China’s manufacturing sector has seen the steepest decline since the records began, affecting the textile, furniture and toy sectors. Civil unrest has begun to rock the Guangdong and Longnan regions.

Michael Pettis, a professor at Beijing University, said it was "very worrying" that a pro-devaluation bloc seemed to be gaining the upper hand in the Communist Party. "I really do believe that we are on the brink of a very ugly period for trade relations," he said.

"In the 1930s the U.S. foolishly tried to dump capacity abroad, but the furious reaction of trading partners caused the strategy to misfire. China already seems to be in the process of engineering its own Smoot-Hawley," he said, referring to the disastrous US Tariff Act of 1930.

The futures markets are pricing in a 6% devaluation over the next year. "This is clearly a big shift in policy and we are now on alert," said Simon Derrick, currency chief at the Bank of New York Mellon.

Hans Redeker, currency head at BNP Paribas, said China's policy switch could set off a dangerous chain of events. "If they play this beggar-thy-neighbor game, it will cause a deflationary shock for the whole world," he said.