A very deep hole

A very deep hole is a place where the US and China have put themselves and everybody else in the world because of the kind of economic interdependence they have to each other. We know that Chinese government has artificially lowered the value of renminbi by 30-40%. Which means that Chinese exports are cheaper while Chinese imports are expensive. Some people might not take it too seriously, but it is a kind of weapon of mass destruction that can outperform any nuke on any given day. Because of the lower renminbi China has become the world's biggest exporter while US has become the world's biggest importer. Due to cheap imports American people have, for quite some time, been spending well beyond their means. The national savings rate is -2% while debt has crossed USD 13 trillion, 84% of GDP. So what does a country which is spending way beyond its means do to buy all those things. It acquires more debt. And who actually gives this money to US? The Chinese, as they are the only ones who are benefiting from the spending of the American people and they are the only ones who have the money to do so. This has been going on for a while. The American people buy beyond their means, the US government acquires more debt by selling bonds, Chinese buy these bonds, giving American more money to buy more. This cycle repeats itself again and again and again. But there is one factor that does not go in cycle along with it; the national debt. The national debt increases with every cycle. Right now it has reached staggering 84%, and it increasing at USD 4 billion daily. And soon enough it will cross the 100% mark. At that point the national debt of US would be more than the sum total of all the assets of US. How will the US government going to pay back this money? Recently, the Greek crisis highlighted the very same issue. The national debt at the time of the crisis was 113%, and the Greece had to be bailed out else Greece would have defaulted on the its sovereign debt. Greece is a small economy by any standards and hence could be bailed out easily. But US is the biggest economy in the world. If it were to default on its sovereign debt, who is going to bail it out and how. By some estimates US would reach this stage in next ten years.

So what is the way forward. There is a loud and growing voice in US and around the world that says that increasing the value of renminbi should be our next step. There has been a lot of influential and powerful people in and out of US congress making emotive and passionate appeals for the same. And as we all know it way too well that most important financial decision are best made with emotions and passion rather than sound thinking. So what is going to happen if Chinese were to increase the value of renminbi. The first impact would be that Chinese exports would become expensive, resulting in sharp decline in demand for Chinese goods. With decline in demand, large number of factories in China would close down or will layoff workers, resulting in large scale unemployment. With the current situation in China, growing rich-poor divide, high frustration and resentment of the people towards government, etc large scale unemployment would be the perfect catalyst for a major revolt/revolution in China, the type which is every government's worst nightmare. A lot of financial pundits have put their money on renminbi to rise. This has led to huge investments in Chinese real estate market. Why? If renminbi were to increase its value by 40%, everything in China will get 40% expensive. So people were to own land or house in China, then its value will increase by 40% when the value of renminbi were to increase. That has led to investors from all over the world investing in Chinese real estate market; which has led to spiraling of real estate prices in major Chinese cities. This real estate bubble will burst as soon as the renminbi appreciates, then everyone will start dumping their assets in China before the bubble is completely burst and the Chinese economy will go in depression like the one US had after its housing bubble burst. Which will cause trouble for all those people who still have jobs left. Long story short there would be big problems in China and would not go away very easily.

Now back to US. With increase in value of renminbi, US imports from China will reduce significantly, but will not affect its national debt in short period. And hence the government has to continue selling bonds to raise money. But this time Chinese would not have the money to buy US bonds (for the fact that their income has reduced as exports have reduced). So the US government will have to raise money from within the country by raising interest rates. We all know how the whole world got affected when sub-prime housing crisis happened in US. Raising of interest rates will create a much bigger crisis as even the prime customers will start defaulting on their mortgages. There is still a huge inventory of over million homes that are up for sale due to foreclosure, the new crisis would bring another set of homes from subprimes customers who were remaining from the previous crisis and many prime customers who now cannot afford their loans.  This will result in a much bigger housing crash in US followed by the crash in the US stock market. With so many people out of homes, buying fancy clothes, gadgets, etc will not be at the top of their minds. US is the biggest importer of the world, also a major trading partner for most countries in the world. Reduction in US's buying power will result in more or less China like affect depending upon their dependence in US exports. This would result in reduction in the value of Dollar, which will further aggravate the problem. The housing crash, stock market crash and lower imports from US will have a major impact in the rest of the world, much worse that what we have seen in the previous crisis. This is not all, China today has the largest reserve of US dollar in the world. So if dollar were to fall, China would have the biggest impact as value of its assets would fall. This will be the third big impact on China after large unemployment and housing crash.

So what is the solution. If value of Chinese currencies is left unchanged, then the US will reach a point when it can no longer pay for its sovereign debt and will lose the ability to borrow further, pay for its imports, etc. Which will in turn cause lots of hardships to Americans as bank interest rates will go up, salaries would be reduced, inflation will hit the roof and dollar will fall; resulting all the problems I listed above falling dollar will cause will happen. If renminbi were to appreciate, then again dollar will fall and almost everything will happen in the same way. So no matter what US and China decides, dooms day is coming. The only question is when. The more we wait to do something, the more harder it would be to do something and the faster we do something, faster everything will go into crisis. The only thing left for us to decide is when we would like to get kicked where it hurts the most.

I know that I have only stated the problem and not given any solution. But if I know the solution this problem, then I would be expecting a call from Sweden rather than writing this blog. So my advice is; enjoy the ride while you can, it is going to be a fairly bumpy ride quite soon.