As China Becomes World's Largest Exporter, What Happens to the Yuan?

China beat expectations in 2009 as it overtook Germany to become the world's biggest exporter. Reuters reports that China's exports rose 17.7% in December, much more than the 4% forecast. China's industrial output grew at a stunning 25% rate and its fourth quarter GDP growth was at least 11%.This rapid growth means commodities prices will likely rise, and it could put more pressure on China's artificially depressed currency.

For investors seeking explanations for rising commodity prices, it's worth noting that China's crude oil, iron ore, and copper imports were all at or near records at the end of 2009. As Reuters reported, China's imports spiked 55.9%, much higher than the 31% the forecast.

The Yuan Still a Focus

What does this mean for the U.S.? There are two ways to generate capital for a country's economy: profits from producing and selling goods and borrowing money. China is winning on the first and the U.S. leads in the second. While China's economy is at risk if the world stops buying its goods, the U.S. will be in trouble if the world -- especially China, which owns $2.2 trillion of our $12 trillion in debt -- stops refinancing that debt.

This leads to the question of China's currency policy and its impact on the U.S.. That's because with China's economy burning so hot (along with a major real estate bubble about which I wrote earlier), policymakers there are struggling with what to do about its currency. The argument for keeping its yuan weak relative to other currencies is that this boosts exports by making Chinese goods relatively inexpensive.

The argument for strengthening the yuan -- by raising Chinese interest rates -- is that higher rates are needed to pop the real estate bubble before it gets any worse and to keep inflation from roaring out of control. But a stronger Yuan would also make Chinese goods less attractive to the U.S., which could damage China's booming export market while further reducing the value of the minuscule interest payments that China receives on its U.S. debt.

I am guessing that China will resolve its currency dilemma based on how that option affects its domestic political situation. Unlike in the U.S., where the unemployed complain but don't do anything to destabilize the government, Chinese unemployment can lead to street protests which make China's leaders extremely uncomfortable, according to The Washington Post.

Status Quo Rules

Ultimately, China's decisions on how much to strengthen the yuan and slow down its economic growth will depend on whether it is more destabilizing for factory workers to be thrown out of jobs due to slowing exports or for its property bubble to blow up a bit more. My hunch is that China is more concerned about the factory workers and it will not raise interest rates enough to throw them onto the street.

But if China does increase the value of the yuan, Reuters reports that it will only be very modest -- about 3%. As a result, China will probably continue to be a big importer of commodities, boosting their prices and making money for investors in the stocks of big commodity producers.

Meanwhile, the economic mutually assured destruction between China and the U.S. will probably keep both economies from taking drastic action to destabilize the current economic truce.
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