China Ready To Cool Down Economy

Some off the cuff musing today on China's economy. China is apparently preparing to cool down it's economy to thwart inflation, by raising interest rates and/or allowing the currency to rise against the U.S. dollar and other currencies. Raising interest rates has a pressuring effect on the currency that would be the same as allowing it to float a little more freely. In other words it would rise just as if it were allowed to rise on it's own , or simply re-pegged at a more realistic exchange rate by the communist government of China.

The effects of a rising Chinese currency could quite well be inflationary in the U.S. in the short term as the price of Chinese imports rise versus domestic and other imported products. Ultimately that would lead to a decreased demand for Chinese products in the U.S., depending on the elasticity of demand for those goods. I suspect that the demand is reasonably elastic for a lot of Chinese products.  However, because there aren't many other countries with a similar manufacturing infrastructure and as cheap and abundant a labor pool as China, the supply curve may be much less elastic. Manufacturers can't switch production plants to another country at the drop of a hat - there's legal complications, there may be sourcing and/or building factories required, not to mention training and distribution issues to solve. these things take time. Not to mention a good number of Chinese exports are no doubt manufactured by Chinese firms, not companies off-shoring production to China. Chinese firms won't have much interest in off-shoring their production to Bangladesh, so they won't be going anywhere. Companies purchasing from Chinese manufacturers, middlemen, will need to source new suppliers. That too takes time.

As a result, there may be inflationary pressure in the United States for goods manufactured in China. That will put downward pressure on Chinese imports and help shrink the trade deficit gap. That's a short term benefit.

On the negative side is the inflation American consumers will face. If the U.S. starts seeing inflation as a result of the stimulus money kicking in during 2010 and 2011, the inflation problems could be compounded by China's actions. How severely depends on how aggressive the Chinese efforts at fighting their own inflation are.  Then again, the stimulus money hasn't really stimulated much so far.

But higher Chinese interest rates can very well lead to a capital inflow into Chinese government securities, which would likely offer higher interest rates than in other countries (again, depending on the size of the interest rate changes).  That would mean that China would have more money to lend to it's customer, the United States, to fuel it's pattern of consumption and spending, thus reinforcing the co-dependency cycle the two countries are in as supplier and consumer.  There are also broader implications that have yet to be considered. Chinas jet-propelled GDP growth which have catapulted it into the world's second largest economy isn't a rate that could be continued forever. Projections of China's economy overtaking the United States as the world's largest, may have to be delayed a few years.

Alright, I've started my head spinning.  More thoughts will follow, pending the actual action of the Chinese government.  It'll give me time to collect my thoughts.