China Gets the U.S.'s Mojo

* Most of you will remember the Austin Power’s movie in which Austin loses his “Mojo”, and spends the better part of the movie trying to get his Mojo back. By the books, Mojo refers to charisma, charm, or a magic spell. And this is what is happening to the US’s economy. We have lost our Mojo. 


The federal government is spending an extra-ordinary amount of money, over 10% of the country’s GDP, while the Fed has monetized over $1.7 trillion of debt in pursuit of returning the US economy to a growth path. Even as these heroic efforts manage to breathe some life into the US economy, these efforts are not enough to curb the massively high levels of unemployment. In short, the US has lost it’s Mojo.


In the history of economics, there are many instances in which an exogenous influence, such as a discovery of silver or gold, or a new invention from which wealth is created, managed to infuse an incredible amount of life into a local economy. And so it is with US and China’s interplay. China has earned its cumulative trade surpluses, and $2.6 trillion of foreign currency reserves through its export oriented industries. In my blogs two or three weeks ago, I expounded on a concept called dead money, which referred to the fact that China holds $2.6 trillion of foreign exchange reserves, which is dead from the perspective of the countries who owe that money. The concept of dead money refers to the fact that so long as this money sits on the balance sheet of China, this claim on the US’s and Euro-zone’s system will remain dormant. If China manages to figure out some way to redeem these reserves for something which they can buy, then the claims on the countries issuing the debt will create problems for these countries, the US being the biggest and most prominent deficit producer. In the meantime, I concluded, that these IOUs are dead money, waiting its turn to emerge from dormancy.


With respect to the local Chinese economy, this otherwise ‘dead money’ is quite alive, and spurring a tremendous amount of growth. In fact, GDP is deemed to be slow if growth is only at 5%. What is spurring the Chinese economy is the influx of ‘export’ oriented orders, along with a massive growth in the local money supply. In fact, the PBC (People’s Bank of China), China’s central bank, sports a $3.3 trillion balance sheet, which is about $1 trillion more than the US Fed’s balance sheet, despite the fact that the US economy is about 3 times the size of China’s. The main asset behind the PBC’s balance sheet is $2.6 trillion of foreign currency reserves, and on the other side of the ledger, the PBC has created local currency, and bank credit which is available for local lending. 


Many people talk about the bursting of China’s bubble, since they believe is no way the Chinese economy can continue to grow at its 9+% pace indefinitely. What these nay-sayers forget to factor in is that China has earned its growth honestly, through its cost advantage which local prices and wages afford. As a consequence of this, exports, and their $2.6 trillion in foreign currency reserves are fueling China’s ascendancy, as well as its domestically oriented economic growth which many contend cannot continue. As long as the Chinese can convert their currency hoard for real assets, such as iron ore, oil and other imported resources which their economy needs, then I do not think the Chinese economy will suffer as much as the western countries they export to. The Chinese miracle is fueled by real fundamental factors. However, when China’s trading partners sink into phase 2 of the ongoing depression, then China’s growth will suffer, but again, not by nearly as much as the rest of the world.


My best solution (in concept) to the current economic dilemma of trade imbalances, would be for China to figure out ways to invest their trade surpluses in the US and the EU, where the deficits have originated. If China were to invest in factories in the US, then such an investment would spur a mini-recovery wherever these factories were built. These new plants would promote growth in the US, since not only will this create new jobs, but there would be a multiplier effect as the local employees at these plants spend their wages in the local economy.


In the 1980s and 1990s, in reaction to US protectionist concerns about Japan’s burgeoning dominance in the global car markets, Japan directed their trade surplus towards the establishment of US based factories. Not only did this help recycle the US’s trade deficit with Japan back into the US, but it also spurred economic growth in the local economies where these factories were built. And this would be the easy answer for China, except for the fact that the average wage in China is a few thousand dollars a year, while that is the monthly wage in the US. Somehow, this differential, approximately a 12:1 ratio, needs to get reduced in order for Chinese money to start flowing back to the US. And these wage differences do not include the tremendous tax and benefits burden, which comes with each US job a would-be investor is contemplating. Taking  the view that a positive outcome is to result from the current trade imbalances, means that China’s surplus has to come back to the US, in one form or another. However, the adjustment process requires Chinese wages to rise, which I have heard they should, and US wages to fall, which is something no one is contemplating, but in my opinion, is evitable. 


Still, the differentials are so great, that even if Chinese wages doubled in the next 5 years, and the Yuan doubled in value vis-a-vis the US dollar, the 24:1 ratio of US labor costs to Chinese costs, will still be skewed by a factor of 6:1. Now if the US is in a full blown depression in 2015, China might offer to build some factories in the US, but will exact significant labor (wage and benefit) concessions, which could bring the cost ratio down to 2 or 3 to 1. While these wage differences are still significant, US produced goods will require less transportation costs, and will not be subject to protectionist tariffs which I expect to be enacted by then. So perhaps a 50% drop in US wages might make Chinese investments in US production facilities viable.


A lot of things have to happen to make Chinese investments in the US more attractive than domestic production facilities: wages doubling, the Yuan doubling, and US wages getting knocked down by 50%. And even then, it is still not worth it, except for political and protectionist imperatives. To expect the last piece of the puzzle, US wages (and benefits), to drop by 50% sounds drastic and unlikely. Of course, if the current deflationary spiral is able to run its course, then wages down 50% might not sound so obtuse. Or if the US is able to unleash some inflation, then perhaps on an inflation adjusted basis, wages might be down 50% anyway.


In short, China has the US’s mojo, and the riddle will be to figure out how the US can get its mojo back. I have offered one such scenario, but I do not see this happening over the next few years. It is likely that events will force a different outcome before China can economically invest in US factories.


* G20 – This weekend’s G20 meeting produced nothing, except a consensus that they favor austerity, once economic growth is assured. In other words, they spent the entire weekend figuring out a creative way to not say there are major disagreements between the spend and pretend US, and the austerity driven EU. More on that later this week.