There has been substantial discussion on the risks that this global economic recovery is facing. Most of the discussion has been focused on a possible double-dip in the US housing market or sovereign debt issues primarily focused on Greece. Although these are serious issues that will cause economic disruptions, we believe that a severe disruption to the economy would come out of China. The biggest risks that we foresee facing China revolve around their ability to slow down bank lending, dealing with the revaluation of the Yuan and trying to stimulate domestic consumption.

Bank lending in China surged by $1.1 Trillion dollars in the first half of 2009. $1.1 Trillion in an economy that has a total output of $4 Trilliion!1 That would be the equivalent of US banks lending approximately $4 Trillion dollars in 6 months. To put this in perspective total Credit Outstanding increased by $662 Billion dollars from December 1999 to December 2009.2 Even with this massive amount of lending Chinese GDP increased in 2009 by only 8.7%.3 Considering that loans grew by 27% of GDP this suggests that the rest of their economy suffered a substantial decline in output.

This increase in bank lending has been fuelling massive speculation in stocks, commodities and real estate. The Chinese government wants to pull the reigns back on this speculation so they have begun to tighten the reigns on future bank lending by increasing reserve requirements and setting lower loan growth targets. Remember that in the history of the US we have only achieved to avoid recession during a monetary tightening phase (1995). Our question is how will China be able to avoid a recession and sustain its blistering growth rate without filling the output gap left by a reduction in bank lending? A lot of talk has been circling around the thought that domestic demand will fill the gap, but domestic demand is 36.4% of China's GDP so it would have to grow by about 56% to fill a trillion dollar output gap.

The next biggest concern for China is the revaluation of the Yuan. There is substantial political pressure from its trading partners to allow the Yuan to appreciate. Even though their current stance is that it is a domestic issue and they will not be pushed to making a change it is clear that if there is not a revaluation soon, these trade partners may start to establish tariffs to fight the trade imbalances. It is now becoming clear that the revaluation will come soon but what is uncertain is the magnitude and timing. Past revaluations have caused spikes in commodity prices and it may also translate to higher prices for US consumers. Price increases at a time when demand is soft could be detrimental to manufacturers in China who are already selling products at extremely low margins.

The last issue is trying to encourage domestic consumption inside China. This will prove a difficult task since there are limited social safety nets and the prospect of unemployment increases as the last two policies are being implemented. A large part of the issue is that the manufactured goods made for export markets are not necessarily demanded by the domestic market. To repeat my point, any increase in domestic demand would really be too small to counter a substantial decrease in investment (lending) and exports.

As the world focuses on Greece and housing, we believe that substantial future risks lie in China. The country is trying to walk a tight rope between reigning in speculative bubbles in stocks, commodities and real estate while maintaining a high growth rate for the economy. There are people such as Jim Rogers who believe that this will be China’s century and that they are where the US was in the early 1900’s. The one thing to keep in mind is that in the early part of our century we went through a period of speculation and overinvestment to eventually suffer through The Great Depression. There has only been two other times that a country has run persistent trade surpluses to become the world’s biggest creditor nation, the US in the 1920’s and Japan in the 1980’s.4 Neither of those situations worked out well so we will be looking for the Chinese economy to follow suit sometime in the near future.

Thank you,

Excelcia Financial Group