Brilliant Analysis of Chinese Economy by Michael Pettis

Michael Pettis has a great story today on SeekingAlpha. Here's the juicy part:

By the way, this exercise should indicate yet again why all the discussions and debate in China and the US – about whether or not China should continue financing the US fiscal deficit – are wholly beside the point, as I have been arguing almost mono-maniacally for years. China cannot finance the US fiscal deficit, nor can any other country. China can only finance the US trade deficit, and it must do so by recycling its current account surplus, either via Chinese investors, or via central bank purchases of US dollar assets.

If there are hot money outflows from China large enough to cause the central bank to lose reserves, the central bank will not only stop buying US Treasury bonds and/or other dollar assets, it will have to sell something, which is most likely to be US dollar bonds. It has no choice.

Hmmmm.... So, let's put on our political economy caps and think about what this means for Treasuries. Overleveraged European banks are dumping U.S. assets, and Chinese investors, apparently, are selling Yuan for dollars to buy them. This means that the CBOC is probably also selling Treasuries or other bonds. Bernanke, meanwhile would love to start buying Treasuries. China would love to wait until Bernanke starts buying to start selling even more. In the end, though, does it really matter? China will sell, and Bernanke will buy. China will pay off their debts, and Bernanke will monetize ours.

However, there will be unintended consequences. First, if Treasuries are kept artificially low, that will push yields higher for everything that's more risky: mortgages, corporate bonds, muni bonds, and everything else. Gold, I think, would especially benefit. Also anything Chinese investors getting their money out of the country want to buy. If they're thinking long-term, it'll be commodities.

A net outflow from the central bank has to be financed by retiring central bank bills or “destroying” RMB. This implies monetary contraction, and it is still difficult for me to see how this would not have a contractionary effect on underlying money.

This is the reason I'm bearish on China over the next couple of years. They could easily go into a depression if their trade surplus goes negative.