Janet Yellen, who in mid-November completed a “fact-finding” trip to Hong King and China, provides some insightful observations into the closely tied monetary fates of China, Hong Kong and the US, as well as China’s Catch 22 paradox of overcapacity. As Yellen points out, US monetary policy is a critical factor for both Hong Kong and the mainland “both Hong Kong and the mainland are currently pegging to the dollar, they are both to some extent stuck with the policy the Federal Reserve has chosen to promote recovery.” In essence, and in confirmation with Zero Hedge’s “vassal theory” of the Sino-US relationship, China has a “considerable interest” in the Fed’s exit strategy. Yellen demonstrates that while China is forced to look to growing its own internal economy now that the export-led, current account surplus model is over, the transition will require yet more stimulus, thereby further inflaming the asset bubble, spurred by the massive overcapacity already in place in the country, and further pushing the country into a monetary-fiscal zone of disequilibrium. This would be exacerbated by any move to strengthen the Yuan, which is what has to happen for the US to keep inflating its troubles, yet won’t happen so long as China continues being in denial about its bubble conditions, thanks to a phenomenal precedent set by none other than the Federal Reserve itself. Yellen won’t go so far as admitting it, but all the ingredients for a massive Chinese (and thus, U.S.) crash are now in place.

The problem for China as it struggles to readjust from an export-led economy, is that admitting a need to focus more internally, would suggest even more stimulus is needed to prop up precisely the sectors where immediate job creation is greatest. For China keeping its population employed and happy is critical which is why “given the difficult in winding down the engines of job creation will make a transition toward a less trade-oriented growth strategy” to take place slowly.

Yellen then highlights some of the critical flaws in the economic model and makes a full circle to what Hugh Hendry was discussing yesterday about substantial Chinese overcapacity (and why he took some not so friendly jabs at Jim O’Neill):

To hold down the renminbi’s value in the face of continuing trade surpluses and sizeable capital inflows, China’s central bank has had to buy dollars at a rapid pace. The result is that China’s foreign exchange reserves have now swelled to over $2.25 trillion dollars (see Figure 3). China’s money supply has also increased rapidly. Inflation in China has turned up, and most analysts with whom we met recognized that the renminbi will need to be revalued and monetary policy tightened to avoid inflation. Even though future exchange rate adjustments seem all but inevitable, they are unlikely to resume until at least the middle of 2010 because of lingering concerns about the pace of economic recovery among China’s major trading partners.

Alas, it is dangerous to confuse wishful thinking with reality. And China is more than likely going to need a persistently weak currency even as it struggle with increase price pressures which will demand that the Yuan rate be let loose again.

And, at the very bottom of it all, is the problem which Hendry highlighted so well - massive overcapacity.

Household consumption is already growing at a robust double-digit pace. The problem is that investment is growing at an even faster pace, so the household consumption share is likely to continue to decline. Moreover, the stimulus packages introduced to counter the global recession have had the unfortunate side effect of acting against reform, since the bulk of stimulus was in the form of increased investment, which primarily found its way into the export-oriented and state-owned sectors, or into infrastructure projects that supported these sectors. The consequence is that the stimulus has exacerbated overcapacity in Chinese manufacturing and increased pressure on Chinese firms to export.

Bottom line - China is screwed, and every false move performed by the Fed, whose actions by implication reflect in China’s broader monetary policy, will be amplified and make the bubble increasingly worse, as the right move here, which is for China to cut down on its stimulus and to focus on the growth of its own economy, will likely not occur before it is far too late. One should just look to the US to see how eager politicians are to step away from a tenuous and ultimately destructive status quo and proceed to do the right things needed to fix a broken system, which however would result in significant popular revolt and most likely a near-certain loss in any future political elections/referendum. This is precisely why the economic system, from a physical system perspective, is teetering on the balance and is about to break.

Full must read FRBSF Economic Letter.

by Tyler Durden via zero hedge
http://www.zerohedge.com/article/janet-yellen-discusses-china-paradox