Today, we will continue from our previous article, Hazard ahead for Australia- interim crash in China. Before we delve into the implications for financial markets, we will first look at the stark choices available to the Chinese government.

First, we have to understand the dilemma faced by the Chinese government. Their number one priority is to ensure social stability. But we have to distinguish between social and political stability. As we mentioned before in Will China fall under popular revolt?, we doubt the Chinese people will rebel against their government and drag their nation down into the extreme political chaos that is reminiscent of the first half of the 20th century. But social instability can undo much of economic growth made over the decades, including further roll-back of liberalisation that was made over the years.

Factors that can undermine social stability include: corruption, mass unemployment and inflation. We doubt mass unemployment alone will pose a great threat to social stability. Back in the 1990s, under the leadership of tough, clean and anti-corruption Premier Zhu Rongji, China could still cope when many unprofitable state owned enterprises had to close shop, throwing millions into unemployment. Today, when corruption is probably a much more serious and endemic problem, perhaps mass-employment and/or inflation will become much less tolerable?

Every Chinese knows that corruption is a problem in their country. Inflation, along with its symptoms (e.g. growing rich/poor divide),? is a growing problem. Unemployment is not yet at a critical level. As long as the Chinese government can finely balance between unemployment and inflation, corruption will be tolerated up to a certain extent. Our guess is that when this balance breaks down, public anger may erupt.

That is where the dilemma lies. As long as the yuan is pegged to the USD, the Chinese government cannot control inflation (see Why is China printing so much money?). But the yuan has to be pegged to the USD in order to keep the Chinese exports competitive so that American consumers can fill in the wide gulf between Chinese investments and domestic consumption. By not allowing the yuan to appreciate, the Chinese government shows that at least for now, they fear unemployment and excess capacity more than inflation.

But there will be a day when they have to tackle the inflation problem. As long as the inflation problem is not solved, there will be rising prices and bubbles in the asset markets. As this gap widens, it will be harder to grow their domestic consumption demand to soak up their growing excess industrial capacity. As there’s a natural limit on how much a human being can consume, this will imply that the growing number of poorer ones will have to consume less (due to inflation), while the richer ones will have more and more of their wealth that cannot be consumed. This will result in them having to ‘invest’ their excess wealth into asset markets, contributing to an even bigger bubble. In other words, the paradox is that the further the Chinese government delay in tackling inflation, the more reliant they will have to rely on American consumers, which means it is harder for them to let the yuan appreciate.

Will the Chinese government have the guts to let the yuan appreciate? All they have to do is to look across the ocean at Japan and that will be enough for them to hesitate. As Satyajit Das wrote in this article,

In 1985, Japan, the US, Britain, Germany and France signed the Plaza Accord, in which they agreed to depreciate the dollar in relation to the yen and the mark by intervention in currency markets. The accord had limited success in reducing the US trade deficit or helping the American economy out of recession.

The Plaza Accord signalled Japan’s emergence as an important participant in the international monetary system and global economy. But the effects on the Japanese economy were disastrous.

The stronger yen triggered a recession in Japan’s export-dependent economy. In an effort to restart the economy, Japan pursued expansionary monetary policies that led to the Japanese asset price bubble that then collapsed in 1989. Economic growth fell sharply and Japan entered an extended period of lower growth and recession, generally referred to as ”The Lost Decade”.

The bigger the bubble in the Chinese economy, the bigger the consequences when the bubble collapses. But if the yuan appreciate too much too fast, it will be pin that pop the bubble.

This is where the next problem for the Chinese lies- the United States. The Chinese cannot allow their yuan to appreciate too much too fast. But the Americans are simply too impatient to wait. With influential voodoo economists like Paul Krugman writing inflammatory articles like this one, we shudder to think we will happen if the Obama Administration heeds his words and bring a trade war between China and the US a step closer.

If there’s a trade war between the Chinese and the US, we can be sure the Chinese government will stir up nationalistic feelings and put the blame on outsiders. This will definitely result in political tensions between both nations.