China’s real effect on our economy

It is easy to blame China for our domestic problems. The argument from Bush and the US Goverment is that because China is keeping the Yuan artificially low against the dollar, the US is losing jobs and running a huge trade deficit. The US Government is asking the Chinese to float its currency against the dollar to help solve this fundamental problem. However, the big issue is that our economy is extremely vulnerable to China, and there is much more at stake than losing jobs to China. By keeping the Yuan low, the Chinese are keeping our interest rates low as they are huge buyers of US Government bonds (as of May 2003, China held $121.7 billion in US Treasuries ranking it 3rd in foreign ownership behind Japan and Britain). From your economics 101 days, you will remember that interest rates and bond pricing work in inverse order. Heavy purchasing of Treasuries increases the price and conversely lowers the interest rate. If China ever decides to sell these bonds it could start a massive chain reaction which would be detrimental to our economy. One of the big reasons for this is that our country is a huge net borrower, corporate-wise, individually and fiscally. All is well and good when we are borrowing at low interest rates heavily financed by foreigners. This certainly drives near term growth. Just look at how the refinancing boom has spurred incredible consumer demand over the last year. However, given the amount of borrowing that we do as a country, we are extremely vulnerable to interest rate risk.

Bill Gross, Pimco's bond guru, paints a scenario in which a devaluation of the Yuan could trigger some nasty consequences:

"A more likely course would posit reduced Asian and U.S. purchases of Treasuries, a diversification into Eurobonds, a stronger Yen and Yuan over the next few years, more expensive U.S. imports after a lag, a sapping of consumer spending power, gradually rising intermediate and long-term rates, a declining housing market and yes a near body blow to America’s financed-based economy for all the reasons outlined in previous pages."

So before we get too excited about domestic growth and the great performance in the stock market this year, let's remember that our economy is not as invincible as we may think. We are potentially vulnerable to the Yuan and other Asian currencies which are indeed overvalued and need to be corrected. When this happens and how this happens will obviously determine the effects on our own economy.

Why is this important for those in technology? Even though technology stocks have performed incredibly well this year and even though Google is talking about going public next year (see an earlier posting), I just do not want us to get too excited about a return to the earlier bubble period. Some of us may have forgotten already as you can see from this NY Times piece yesterday about investors' appetite for risky stocks. What is important is that we do not use the market as our sole proxy for the strength of our economy as it can be deceiving. Companies still have to generate meaningful earnings and cash flow. This macroeconomic backdrop certainly has implications about what types of companies I believe will have a better chance of performing during the next few years. I hope to address this topic in a future posting.

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