Saturday, October 8, 2011

The Great Chinese Economic Paradox

Outright Disclaimer: This is purely a hypothesis and it may be completely wrong and baseless. This post intends to just open up a possible perspective in the economic dynamics amidst volatility in global capital markets.

Currently, we are under the asusmption that China holds a lot of foreign reserves and it is indeed true that countries, banks are lining up at Beijing in the hope that some relief can be sought from there with the vast foreign reserves that China has. So far so good - there is not an iota of doubt that currently, China is the largest holder of US T-Bills, and Euro Bonds from different countries and these very bonds are helping as collateral to provid the lines of credit to Chinese exporters and western importers to enable transactions take place. However, my opinion is that all this will only work well to the extent exports from China do well and payments are being honoured.

Now it would be very naive to assume that with constant devaluation of USD and EUR, the value of Chinese foreign reserves would keep on depreciating and if China knows this fact, why is it continuing to buy these reserves? Partly the answer lies in the fact that China is trying to establish economic hegemony and as it acquires this debt, it is managing to gain access to cheaper resources as well in other countries along with ensuring that the exports go on as smoothly as possible. Resources now belong to Chinese governments in a number of countries like - African countries for timber and minerals and oars; quarries and steel mines in Australia so on and so forth.

However, the biggest worry from Chinese economic activity is something else and can have implications far worse than a simple default on sovereign debt from western countries and banks [that is a given and it is only a matter of time before it explodes] For the last 10 years, China has demonstrated remarkable progress in building up the infrastructure and a lot of modernization. Something has to pay for that as well - is it possible that China has actually utilized the holdings of these potentially toxic assets [western bonds] as collateral to borrow money for building up all of the modern facilities?

If that is the case then banks and investors are in a double whammy situation - in case of a demand for payments come in a jiffy, China can simply wash its hands off as the value of collateral is tied to Euro and US bonds! The infrastructure is in place now and all that China has to do is gain access to the remote control similar to that of US!. So if one thinks that China should be worried if the toxic assets of western world will affect China severely - it acually ma be the other way around. The very western world should be worried because China has managed to keep itself in a win-win situation; If the recovery of western debt and concerns go as expected, then China is fine with a lot of high yield debt in hand. The recovery will have no major impact for the western world as they have auctioned bonds at very high yields and low prices! On the other hand, if the western sovereign and banks fail, China will also stop payments citing challenges with the collateral security!

Think about this perspective as it will send down negative jitters across global bourses and in such a condition, the bear market conditions can extend for another 15 to 18 months!

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