Chinese Mercantilism

Includes: CAF, FXI, GXC, PGJ
by: Cynicus Economicus

I will start with an apology that it is so long since my last post, which is due to my having been busy with my 'real' work. There were a host of subjects that I would like to cover, but the subject that grabbed my interest was China.

One story about China of particular note was an Economist article on the situation of labour in China. The increasing cost of labour in the coastal areas is creating ever more incentive for the movement of less skilled work into inland China, and that this will see/and is the result of the coastal provinces continuing their steady rise up the value chain. This process has been ongoing, and will allow (in principle) for China to maintain economic growth for a long time yet, all the while without losing the ability to compete in the lower value added industries on which its initial success was founded.

For the rest of the world, this ability to manage a transition from low value added to high value added whilst retaining the former, presents an ongoing problem for competitors. This is the key difference between the emergence of China and countries like Japan, South Korea and Taiwan; the depth of China's labour market. This depth will allow China to compete in every segment for a long while yet, allowing an ever greater dominance of Chinese exports.

Another aspect of the Economist article that was interesting was the concentration of strikes in China in foreign enterprises, reflecting points I made a long, long time ago. The point in question was the way in which China seeks to bring in foreign investment, methods and technology, whilst at the same time weighting the dice against the foreign companies. In the case of strikes, the authorities seem very willing to look on (and take no action) in the case of strikes in foreign companies, but far less willing to tolerate stikes within domestic enterprises. In a post I made a long time ago, I pointed out the many ways in which China sought to disadvantage foreign companies, and it seems the policy is ongoing.

Although in some respects investing in business in China is a risky choice, China is managing to weight the dice even further in their favour. A while ago, I discussed rare earth metals, and that China (which is the dominant producer) was seeking to restrict exports. This is a recent article on the subject:

The United States Magnetic Materials Association (“USMMA”), a trade association representing domestic high performance magnet producers and suppliers, today warned of impending shortages of rare earth materials needed to support domestic manufacturing in support of emerging green technologies like wind generation, hybrid vehicles, and new battery development, high-tech consumer products like mobile phones, PDAs, MP3s, and national security and defense systems.

Late last week, China, the world’s largest rare earths producer, announced new plans to cut rare earth export quotas by 72 percent for the second half of the year. According to China’s Ministry of Commerce, foreign shipments will be capped at 7,976 metric tons, down from 28,417 tons for the same period last year.

In restricting exports, until such time as alternative sources can be brought on stream (15 years according to the US government), China is effectively forcing companies that use rare earth metals to set up operations in China. In so doing, they will rapicly accelerate the process of manufacture of high-tech devices and the importation of other technologies. All the while this is taking place, despite discussion of RMB revaluation, the RMB remains undervalued. The head of the IMF China mission recently had this to say:

WASHINGTON (Dow Jones)--China's currency is "substantially" undervalued despite Beijing's recent decision to appreciate the yuan, the head of the International Monetary Fund's mission to China said Wednesday.

China has held up the IMF staff report for the fourth year running, objecting to the fund's characterization of its currency and pressing the board to omit its finding.

"The RMB remains substantially below the level that's consistent with current fundamentals," said IMF China Mission Chief Nigel Chalk, referring to the renminbi, another name for the yuan, on a conference call with reporters.

Under pressure from Beijing, the IMF board was at odds how to define China's exchange rate. "Several directors agreed that the exchange rate is undervalued," the IMF said in a notice posted late Tuesday evening. "However, a number of others disagreed with the staff's assessment of the level of the exchange rate, noting that it is based on uncertain forecasts of the current account surplus."

What we are really seeing is yet more of China's strategy of mercantilism, in which they continue to seek any advantage that they can get, without any regard to the concept of free and fair trade. Of course, the most interesting point about China's mercantilism is the resultant strength of China's export machine. In a recent article in the Telegraph, Edmund Conway illustrates the essential problem that is confronting the Western economies:

[Mervyn King]Sitting at a summit listening to his fellow central bankers and finance ministers go round the table and explain how they would escape from the economic doldrums, he realised, with both horror and amusement, that they all had precisely the same plan: export their way out.


In other words, the US and UK's plans to focus on exports as a source of growth in the future are dependent on the world's big exporters – and specifically China – suddenly discovering an appetite for those American and British goods. Fail in this and a double-dip recession is almost assured.


The reality is that just as the US and UK are in most need of demand from Chinese consumers for their goods, Beijing is facing an economic crisis of its own, and is resorting to its most reliable weapon: exporting the hell out of it.

This is the problem writ large. China will do anything to keep economic growth going and, as long as they do so, their export policy will hinder any possibility of rebalancing of trade, and will continue to see the hollowing out of Western productive capacity, increasingly including higher added value goods and services. The most puzzling aspect of this is that, despite lots of noise from China's competitors, the noise just remains that; noise. It never translates into substantive action, in particular from the US.

For the underlying reason for the lack of action, the answer must lie in the reliance of the US government on Chinese funding of deficits. It is a spiral of decline, in which the purchase of treasuries by China holds down the value of the RMB, China uses the low valuation to support exports, the exports depress and destroy productive capacity in the US, and the US needs to borrow more money from China, to make up for their poor economic performance. The more money they need to borrow, the more fearful the US government becomes about taking action to halt the spiral. As I have long argued, China must be confronted, but in order to do so, the US must take the pain that will follow such action.

And such action will indeed be painful....but the potential extent of the pain just keeps growing. That is the nature of the spiral.


None of this is to say that all is perfect in the Chinese economy. For example, as I posted a couple of years ago, the Chinese construction boom has been spurred by the purchase of apartments that have been left empty, and which have been purchased as speculative investments. This trend has (finally) been noted by several analysts, and suggests that a severe bubble is in place.

I have also been looking at some of the HSBC reports on China, and they have made interesting reading. China, due to the opaque nature of the government, is a country where you feel that analysis is somewhat like trying to read tea leaves for the signs of the future. One interesting report was that there are some problems on the horizon for China's local government, with this from an HSBC (1):

New Century Weekly – a financial newspaper in China – reported this week that a recent China Banking Regulatory Commission (CBRC) investigation had found that of the RMB7.7trn extended to local financing vehicles as part of stimulus funding, 23% (or RMB1.8trn) went towards projects that may ultimately have problems in servicing their loans.

The problem was that, as part of the Chinese fiscal stimulus, local governments were forced to borrow from banks to fund infrastructure projects, and these loans are now going sour. It seems that, even in a country like China, where there is a strong need for new infrastructure, fiscal stimulus presents risks that (to use a cliche) bridges will be built to nowhere.

There are plenty of other signals that suggest that the dragon may not be as fit as it appears, and it will be interesting to see how China fares in the coming year. As I have mentioned the opacity of China is such that analysis of what is taking place is never easy.

(1) HSBC Research, 29 July, 2010, China Economic Spotlight,