Chinese Consumers Will Be China's Biggest Driving Force of Demand Soon.

U.S. Government officials are pressuring China to let the Yuan appreciate.  Their argument is China buys the USD to keep the Yuan artificially low which helps fuel the Chinese export driven economy.  Tim Geithner’s belief is that if the Yuan appreciated and Chinese goods became more expensive, the USD would be more competitive and U.S. manufacturers would export more goods.  Thus, helping the U.S. economy and alleviating our current account deficit.

However, while U.S. officials blamed China for currency manipulation, when the FED engaged in QE2, the FED manipulated the USD too.  Germany and China, quick to point out our hypocrisy, have merit in their claims.  As more dollars enter the economy, every other existing dollar must be devalued to make up for the excess liquidity.  It is irrational to think we can simply just print money without consequence.

A recent report from the People’s Bank of China showed China’s M2 money supply grew by 19.5% up to the month ended November 2010.    To ease inflation, the Central Bank already raised the reserve ratio in attempt to soak up liquidity.  But, as Chinese inflation increases above 5.1%, China will have to either raise interest rates or let their currency appreciate. 

If China raises interest rates, more money will flow into the Yuan to take advantage of higher rates causing even greater pressure on the central bank to buy even more USD to keep the currency pegged at current levels.  This will only perpetuate inflation as even more liquidity is added into the system.

Therefore, the only way for the Chinese to fight inflation, and it will happen, is to let the Yuan appreciate.  When this does happen, Chinese goods will become more expensive.  U.S. consumers will face higher prices and a sudden decrease in their purchasing power.

The argument that China depends too much on U.S. demand and cannot afford to let the Yuan appreciate is nonsense.  China has 1.3 billion people.  Their savings rate is over 50% whereas the U.S. consumer saves around 5% (before the financial meltdown it was 1-2%).  U.S. consumers can no longer afford Chinese products because they have virtually no savings and extremely high debt.

It will not be long before the Chinese economy no longer depends on U.S. consumers.  As hundreds of millions of Chinese increase their standard of living and move to urban areas, they will become the driving force of demand.