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Buckle Up For A Bumpy Ride

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September 2005
Buckle Up For A Bumpy Ride

Will a deflationary China depress us?

BY DHAIVAT V. PANDYA

Attention Wal-Mart shoppers! The prices you pay for sneakers, sweat shirts, toys and thousands of other items made in China are likely to rise soon. This could be a rude awakening for U.S. consumers for whom the "Made in China" label has been a ticket to surprisingly low cost goods.

The rise of China coincided with the economic setbacks suffered by Japan and Southeast Asia in the late nineties. Moreover, post 9/11, the U.S. and European economies suffered heavily. China, meanwhile, continued to expand by 8-10% during these years.

One measure of its increasing influence on U.S. economy is the fact that China has been buying U.S. Treasury Bills, indirectly helping finance our mammoth debt. This has helped stabilize the long-term interest rates even in the face of short-term rate hikes by the Fed ? thus stabilizing the housing market, and in turn, the U.S. economy. Hence any dramatic turn in this delicately balanced interdependency can certainly be a cause for concern.

There is yet another factor that further compounds the interdependency between the two economies. Certainly one reason for China's rise as a manufacturing giant and global cost-cutter has been its strategy of undervaluing its currency by pegging it to that of the U.S. dollar. Since 1995, it is this, which has helped it sell shiploads of merchandise to American consumers.

The increasing reversal of the manufacturing base of these countries has been another cause for alarm. Already, few American manufacturers can compete with Chinese prices. Chinese manufacturers are also rapidly moving up the food chain into semiconductors, telecom equipment, and other sophisticated digital devices. To boot, outsourcing of U.S. manufacturing to China caused a major loss in employment, while weakening the once strong U.S. manufacturing base.

If the Chinese start dominating other industries, some fear robust pricing will never return to these sectors. "China's prices are becoming global prices," Morgan Stanley economist Stephen S. Roach wrote in a recent report. Indeed, China has already been the dominating pricing-power since the past decade in many industries such as consumer electronics and apparel.

Not surprisingly, U.S. policymakers are concerned and have been threatening China with possible tariffs on its imports, thereby encouraging it to revaluate its currency. Beijing has been under considerable pressure to update the Yuan, which is currently valued at 8.11 to a dollar. The thrust is for China to hinge the Yuan to the free market supply-and-demand (just like other major currencies of the world), rather than to the U.S. dollar. This would theoretically result in a level playing field while helping ease the massive U.S. trade deficit.

At their end, the Chinese worry that doing so would affect its global competitive edge and may even result in the bursting of their economic bubble. Yet, driven by the increasing pressure, China finally appreciated the Yuan up by 2.1 percent (from 8.28 to 8.11) during the third week of July.

Following are some of the red flags and repercussions of impending changes relevant to China that economists have speculated on:

? Unhooking the currency peg would slow the Chinese investment into U.S. Treasury, and thereby force us to face the perils of its mounting national debt.

? Once Chinese currency gets stronger in the global market, U.S. investment firms will start losing foreign investors. These factors could possibly devalue dollar against Euro, Pound and Yen, and may cause trillions of U.S. debt unsustainable.

? The rising long-term interest rate would also raise the mortgage rates and could possibly burst the housing bubble in the nation.

? China will start buying American companies on a large scale; this could promulgate a new Chinese era in the American market.

? With Chinese products steadily costing more, rapid inflation could pose a problem ? in spite of the several rate hikes by the Fed in recent months.

? Precious metal prices, including gold, could appreciate further (As the Yuan strengthens, China would buy more gold)

? With Chinese goods loosing its cost advantage, manufacturing could shift into countries like Vietnam, Thailand, and Indonesia, to name a few. It could also boost the huge demand of the local U.S. manufacturing sector which can ultimately increase the employment rate and can balance out the negatives

The measured change to the Yuan may appear small, but may be a prudent approach compared to dramatically manipulating the 40% undervalued Yuan, which could have a disastrous domino effect. Some economists and policymakers have warned that a deflationary China poses a real threat to the world.

[Dhaivat V. Pandya ("DP") is a Loan Officer at Ping Mortgage Company, Alpharetta, Georgia. He has an Executive M.B.A degree with a major in finance from Rutgers University. He can be reached at (678) 591-3436 or dp@pingmortage.com]

Moneywise is hosted by Rajesh Jyotishi with Shalin Financial Services, Inc.

An Investment Advisor Representative of FSC Securities corporation. A Registered Broker Dealer. Member of NASD/SIPC. For questions he can be reached at 770-451-1932, ext. 101


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