China, the Next Big Blow up? Excessive Exports a Risk Factor?

The Fall of Icarus by Rubens 1633

Intuitively, large foreign account reserves should be a cushion against runs on the local currency especially for countries with high foreign debt levels or lots of foreign investments that at some point need to be repatriated. If you don’t have enough foreign currency to repay, crisis will surely follow as we have seen during the many Latin-American or Asian balance of payment crises. As such, China’s enormous reserves of about 5-6 percent of global GDP should be reassuring, but as Michael Pettis explains the risks that threaten large developing countries are quite different from those smaller countries can experience.

“The risks that China faces today (and the US in the late 1920s and Japan in the late 1980s) is of excessive domestic liquidity having fueled asset and capacity bubbles, the latter requiring the uninterrupted ability of foreign countries to absorb via large and growing trade deficits. These risks include an explosion in domestic government debt directly and contingently through the banking system.”

Quite similar to what countries rich in natural resources often experience, where large inflows of foreign currency and current account surpluses cause bubbles to arise. And importantly, as foreign reserves cannot be used to solve the problems the solution lies domestically through higher interest rates, less lending, stronger currency and consequentially a less competitive export industry.

We all know what happened to the US and Japan, hopefully China will manage better.

Read the whole post over at China Financial Markets here