Opinion     

How will the downgrading of U.S. credit rate affect China?

Updated: 2011-08-25 By By Wu Chang

• First, due to China's high inflation, it can no longer give high rates of return to investors. Foreign investors such as Anthony Bolton and John Paulson, once poster children for the China growth story, suffered substantial losses on their investments here. Foreign investment can no longer meet the Chinese government's demands for ever-increasing foreign exchange reserves. China can now only rely on trade surplus, currency appreciation and higher interest rates to add to its foreign exchange reserves. There is a little room for RMB appreciation. But for higher interest rates, there is no room at all. If U.S. interest rates rise after the downgrade, the interest rate spread between the United States and China would narrow, making it even more difficult for China to obtain foreign exchange reserves. Moreover, the ability of the U.S. and the rest of the world to consume is diminishing rapidly. China's exports will soon begin to feel the shock of a sluggish global economy. Meanwhile, China's demand for imports - luxury goods in particular - will grow gradually but quickly. Thus, its trade surplus may also shrink.

  Second, China's import demand is hard to reduce, and its exports may drop sharply with the decline of the global economy. Foreign capital could leave at any time. Once China starts running a trade deficit, its capacity to accumulate foreign exchange reserves is very limited. This would send the yuan's exchange rate off a cliff. According to the People's Bank of China, China's broadest measure of money supply, M2, reached 79 trillion yuan (US$12.4 trillion) in July. But its investment in Treasury bonds and others United States debt instruments is only US$1.5 trillion. The RMB exchange rate is supported by China's trade surplus and massive foreign exchange reserves. Once China can no longer maintain the exchange rate, the yuan will go the way of Zimbabwe's currency.

  China's domestic and financial markets connect to the world though trade and foreign exchange. That's why China desperately wanted Congress to raise the U.S. debt ceiling and the Fed to implement a third round of quantitative easing. China can't bear a sizable contraction in U.S. consumption and a tighter U.S. monetary policy. Without foreign exchange reserves, all bubbles will burst as currencies revalue and asset prices see sharp corrections.

  Although the U.S. subprime mortgage crisis might not seem to have affected the Chinese economy back in 2008, China was actually hit hard and later carried out a massive stimulus package. The panic in China after the Standard & Poor's downgrade stemmed from fears of similar fallout. China can endure a weak dollar and current levels of inflation, but it can't afford losing its foreign exchange reserves.

  The author is a commentator on financial and economic issues. He can be reached at abnerwoo@gmail.com

  Opinion articles reflect the views of their authors, not necessarily those of China.org.cn.

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