Tensions Cool, but the Overheating Chinese Economy Does Not

A bitter and until recently escalating brawl between the world's two largest economies seems to be on hold for the time being. In a statement over the weekend, Treasury Secretary Timothy Geithner announced that a report looking at whether China is a currency manipulator would be delayed. The report was due in the middle of April.

The move marks a cooling in the feud between the two countries. Some in Congress have sought to pin the financial crisis and high US unemployment on China, at least in part. By keeping its currency pegged to the dollar and artificially low, some high-profile lawmakers and scholars argue, China has fed global imbalances and in effect siphoned off jobs from other countries. The April 15 report was seen as setting the stage for more arm-twisting and the threat of massive tariffs if Chinese authorities failed to comply.

Investors should breathe a sigh of relief following the Treasury Department's levelheaded decision. A trade war between the world's largest trading partners is the last thing the global economic recovery now materializing needs. Moreover, a gradual appreciation of the yuan seems to be in the cards anyway, and the cooling of rhetoric only makes it more likely by allowing Beijing to avoid the impression that it is caving into Washington's demands.

Other Problems Loom

That, however, raises a much more important question for the markets and one that was obscured by the recent political grandstanding. China needs to manage its runaway economic growth in order to avoid rampant inflation and the prospects of a hard landing. China Construction Bank chairman Guo Shuqing is now the latest highly placed figure to declare that growth above the 9.5% level that the World Bank forecasts for the current year would "be very problematic."

And yet the expansion in the first quarter pegs growth at closer to 11% or 12% by many estimates. The danger of such blistering growth is that capital gets funneled into wasteful projects. Much of the unprecedented liquidity injected into China's closed financial system as a response to the financial crisis has already found its way into the property market and is leading to soaring prices. American investors with a knack for spotting unsustainable trends like famed short seller Jim Chanos have warned of a coming meltdown.

The danger is not lost on many Chinese observers. Growing too fast will lead to "more duplication of construction, more excess capacity and higher waste of capital," Guo told the Financial Times. Indeed, there has been a steady trickle of horror stories about vacant office buildings and barren cities seeping out of China. And the lack of trustworthy government figures there makes investors even more nervous.

Letting the yuan gradually appreciate, then, is now largely in Chinese interests as well. Export growth would slow but domestic consumption would get a boost thanks to a stronger currency. A badly needed rebalance in an economy with too little consumption and too muchdependence on investment would become more feasible. A more concrete roadmap along these lines is widely expected when Chinese president Hu Jintao attends a nuclear security summit next Monday in Washington.

Of course, letting the yuan rise in value would come at a domestic cost. Chinese exporters would take a hit and Beijing needs to do what it can to cushion the blow. That is a tall order in a massive, rapidly developing country like China, where the government has to strike a precarious balance between absorbing loads of newly urbanizing citizens into the labor force while avoiding overheating. The heckling and chest-thumping coming out of Washington, meanwhile, makes walking that tightrope even harder.

Investors should welcome signs that cooler, more practical views now seem to be prevailing. The even trickier issue of how to steer a red-hot Chinese economy, though, lies ahead.