Beijing Duck

Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke and other polished cabinetry are visiting China later this week. They'll see fields of skyscrapers, traffic jams of new cars and designer couture replacing the old Maoist uniform with five buttons and too-long sleeves. In other words, we've got the Chinese right where we want 'em.
Sure, the China Miracle is impressive -- double-digit economic growth, exports up 30%, a $150-billion trade surplus and a trillion dollars of foreign currency in their treasury as reserves. The prevailing opinion is that at any moment, China can stop funding U.S. budget deficits by not buying our bonds -- so Messrs. Paulson and Bernanke should come hat in hand and beg for indulgence. Don't believe it.

Your hotel will probably be on a street that didn't exist two years ago. The traffic jam getting you there? It's from the 1.4 million new family car drivers in Beijing, now just learning how to drive -- and not too well. Think of China as a bunch of high school kids (albeit with strict parents) with new driver's licenses and you won't be far off. Don't give them the keys to anything. Be a little coy. From the consumers to the government, they are simply adolescents.

China consumes one-eighth of the world's energy, one in four tons of steel and aluminum, and almost half of the world's cement. According to Stephen Roach at Morgan Stanley, half of China's GDP is fixed investment. They pay for this with loans from Chinese banks backed by our dollars. Like a teenager who stole Grandma's checkbook, the Miracle seems to be based on writing bad checks.

They can't handle our dollars. Every time the Fed increases money supply and you and I buy shirts and toys, dollars end up in China. As modern gold, these dollars are used as collateral for banks to write loans against. Each way you look in Shanghai, you see the equivalent of the Houston skyline, marble facades on tall postmodern glass and steel buildings. As far as I could tell, over half these buildings are still empty. In fact, I noticed families living in the rubble of the lobbies in many of these buildings. Yet even more skyscrapers are under construction at every point of the compass. China is looking more and more like bad Japanese flashback.

Call it Communist Cronyism. Nonperforming loans are an anchor on this system. More than once, China has dipped into its reserves to bail out its banks. A rising yuan has attracted investment funds; Mr. Paulson's old firm Goldman Sachs and the rest of Wall Street are busy recapitalizing Chinese banks, whose bad loans have been moved off to other entities. One bank yet to recap is AgBank, with a reputed $90 billion in bad loans. This is real money -- a giant black hole that needs to be dealt with very carefully.

At the same time, the U.S. National Association of Manufacturers -- wow, we still have manufacturers in the U.S.? -- has been lobbying this travel group hard for the Chinese yuan to float higher and the dollar to weaken. If it moves 20%, China's labor becomes uncompetitive and will be toast, as crispy as Peking Duck. Why the U.S. would want to give up cheap shoes and electronics is beyond me -- a dollar drop is a consumption tax on Wal-Mart and upscale shoppers alike. Chinese workers make $1.80 an hour, including all benefits. Unless the dollar drops by half, I doubt a single new manufacturing job in the U.S. will be created.

Their stock market could help. China is filled with entrepreneurs who build companies, not buildings. I spent 10 days in China this month meeting with investors. They are smart and hungry but crippled with Enron accounting. On Jan. 1, listed companies must start releasing two sets of numbers -- Chinese earnings and then calculated again using international standards. Many will start to show losses. Ouch. China is scared to open up because the first move might be to short the whole damn country. George Soros has been sniffing around, and they won't let him in. Outsiders need to be licensed as Qualified Foreign Institutional Investor with a quota -- currently less than 1% of total capitalization. Doesn't sound like a market economy to me. The total value of U.S. stocks is 20 times as large for a reason.

Adolescents eventually grow up. China is growing in spurts. They've got jobs and piles of debt. They need to keep working to pay it off. I actually think the U.S., with its immense wealth, is the main banker, not the Chinese floating our hopefully shrinking budget deficits. We are the ones with the leverage. Stick with the currency peg and make China open up their markets to competition and real outside financial scrutiny.

Link to Andy Kessler's website