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China is the solution

31/03/2009

The main points of our discussion at 29.3.2009,

  1. Major assumptions

    Analysis of the causes of the economic brake down.

    1. Our major assumption is that due to the emergency situation, the world economic crisis has to be treated with very short term tools (expected result up to one year).
    2. Every day may be THE DAY of a new collapse of a major financial institution with catastrophic consequences.
    3. China is a major economic force nowadays. If it wants to defend its economic interests, China has to take global economic responsibility.
  2. The World’s major economic problems are the consequence of USA trade deficit, whose accumulation started about 25 years ago, with an increased momentum in the last years.
  3. The deficit was partly covered by China. It created about 2 trillion US$ federal reserves in China and approximately the same amount in other countries, mainly in Japan, other East Asian countries and oil exporting countries.
  4. Chinese reserves are mainly in US government bonds and bonds of other major US companies, as their liabilities are partly guarantied by the US government.
  5. The accumulation of US trade deficit in continuous growing grade created a world financial system, which gave loans based on mortgaged assets. As it appears the assets have been unrealistically overvalued. These loans were later “packaged” and sold worldwide, (partly back to exporting countries).
  6. The credit crunch started, when the trend of real estate prices changed its direction.
  7. Within a year, since the first signs the crisis appeared, the assets values were reduced world wide by tenths of percents, while the liabilities of the borrowers remained on the same level. This phenomenon caused deficiency of mortgage coverage and subsequently problems of liquidity to the system.
  8. The crisis affects also China as a major creditor of the USA, and its investments are endangered.
  9. With the collapse of US and world economy, China and other export oriented economies have lost markets for their merchandises.
  10. China can’t replace in the short term the US and European markets with domestic demand as supplement to lost markets.
  11. If China uses only economic tools (such as revaluation, interest rate reduction, taxation etc.), it cannot replace even partly the loss of US and European consumption demand.
  12. Economic measures alone will have no immediate impact on the economic behaviour of the population (saving rates), unless it will be paralleled by social legislation.
  13. Social legislation has long term influence on the society. It has to be very cautiously judged and needs long political procedures.
  14. As a consequence of the economic crisis, the demand for US goods will be also reduced and the closing of its trade deficit will be a very long process.
  15. Even if the USA will reduce substantially its demand for imported goods, it will not be able to balance its “trade deficit” in the short term.
  16. The US policy of bailing out Banks and Financial institutions, purchasing toxic assets etc, will further increase the debts of US government. These steps will create on the long term a devaluation of the US$, and in parallel it can cause an outbreak of inflation.
  17. Since the banks’ main problem today is to increase their liquidity, the money that is poured into the financial institutions by the US and European governments is not transferred to the economy.
  18. Solution to the problem suggested by us;
    1. To help restart the world economy, China has to pour back the reserves it is holding in US$ into the USA economy.
    2. Until now it has done it by purchasing bonds. The bonds are loosing value even if they are guaranteed by US government. (Due to the risk of outbreak of inflation and/or devaluation of the US$.)
    3. We suggest an alternative policy of investing directly into US economy and purchasing assets; for example shares of major US and European companies, real estate, as well as strategic investments (when purchasing the majority share of a company).
    4. By doing so, liquidities will increase in the US and European economies.
    5. Since the price of the assets was reduced substantially by the crisis and they seem to have reached the bottom, China will most probably gain substantial profits by that policy.
    6. Due to its overwhelming weight in World’s economy, China will become a market maker.
    7. To reduce the danger of conflicting situation with US and Europe, when a strategic investment is done, China has to do it in tight coordination with the US, and respectively with European governments.
    8. To implement this policy, the Central bank of China has to create several investment funds, in which it will invest large part of China’s foreign currency reserves.
    9. To solve the problem of the management of these funds, it has to recruit managers of investment funds and investment banks, who were recently released from their jobs in the financial institutions. Most of them are excellent professionals and if they are employed in a correct framework, they can be very useful.
    10. To finance these purchases, China should avoid selling the Bonds it is holding in foreign currency reserves, because this will degrade their value. China should instead pledge the bonds to commercial banks and take loans against it.
    11. As a by product of the suggested policy, banks will intensify their loaning policy and this will restart the economy.
  19. The expected consequence of the suggested policy.
    1. US and European economies will get back liquidities.
    2. By purchasing assets in today’s prices, China will profit or at least preserve the real value of its UD$ reserves.
    3. The upward trend of financial markets and real estate prices will renew the activity of financial institutions.
    4. An increase in the value of World wide assets will enable the banks to re-evaluate the pledged assets of its creditors and allow them to increase lending.

If inflationary pressures will appear in China, it will have chance to revaluate its currency, and by doing so, slowly, on the long run the unbalances of world economy will be reduced.

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