Predictions for 2010

The global economy is much more stable today than it was at this time last year, but that doesn’t make 2010 any easier to predict. In January 2009, the debate was all about numbers. Would China’s economy grow by 8 percent as the government was predicting, 7.2 percent as the World Bank concluded, or considerably lower as many economists feared? By how much would China’s exports decline? Would the Shanghai Index recover from its precipitous 66 percent decline in 2008? If so, by how much?

In 2010, numbers are not the issue. China’s economy will continue to grow by at least 8 percent, and perhaps more. After scoring an 80 percent increase in 2009, the Shanghai Index will benefit from a strong economy and continue to be a good place to put your money. In 2010, the questions are more qualitative, and so are my predictions.

Prediction #1: By the 2010 year-end, inflation will be the big economic story in China.

China’s fast growth in 2010, combined with continued growth in India and other developing markets and a bottoming of the economies in the developed countries of the world, will put pressure on prices of everything — especially energy, metals and food. In response to the global financial crisis, central bankers around the world, including those in China, flooded the markets with money. The vast amount of liquidity that is now sloshing around the global economy will result in global inflation tomorrow. With manufacturing still such a large part of its economy, China will feel the impact.

Prediction #2: China will continue to peg the yuan to the dollar at 6.8 to 1 USD until it is confident that downward pressures on the dollar have eased.

In managing its currency, China has to balance two issues. First, it must consider the impact of its currency policy on trade. Second, it must consider its impact on the $2 trillion or more of foreign currency reserves, much of it dollar-denominated, that it currently holds.

In this context, China is constantly monitoring the value of the dollar against other major currencies such as the Euro. In July, 2005, the Euro was approaching parity with the U.S. dollar as one dollar could purchase 0.85 Euro. China took this opportunity to counter political pressure from the United States to broaden its peg to include other currencies by doing just that. Also in July, 2005, China announced that it would peg the yuan against a basket of currencies, including the dollar, and would allow its currency to trade within a range.

Over the following three years, the value of the yuan against the dollar increased by approximately 20 percent as the exchange rate strengthened from 8.3 to 1 USD in July 2005 to 6.8 to 1 USD by July 2008. As a result, the value of the dollar-denominated assets held by China declined by 20 percent. For every $1 trillion of dollar assets it owned, China lost $200 billion. During the same period, the Euro strengthened by approximately 33 percent against the dollar. By July, 2008, one dollar only purchased 0.65 Euro.

With the dollar at a low point, China re-pegged the yuan to the dollar at the then exchange rate of 6.8 yuan to 1 USD in July, 2008. This caused the yuan to strengthen against other currencies like the Euro — at least for a while. In the wake of the financial crisis, the dollar, and therefore the yuan, strengthened against the Euro as investors around the world flocked to the greenback. By early 2009, the dollar had appreciated by 20 percent. At its high point, one dollar could purchase 0.80 Euro.

With the United States facing $1 trillion budget deficits “for as far as the eye can see,” the U.S. Fed printing money and U.S. debt at an all-time high, however, the dollar has been in free fall ever since. From its high against the Euro in March, the dollar declined by over 15 percent during the year. Today, one dollar can only purchase 0.70 Euro, as any American traveler to Europe can attest. If China’s currency had been heavily weighted to the Euro during this period, the country’s dollar-denominated assets would have declined by a further $150 billion for every $1 trillion of assets held. As a result, the yuan and the dollar are now linked together in a deathly spiral against the Euro and other major currencies of the world.

In this context, expect China to continue to peg its currency to the U.S. dollar until it is convinced that the U.S. government is committed to a strong dollar policy.

Prediction #3: Geely will acquire Volvo from Ford, and this acquisition will be a turning point for acquisitions of industrial companies by Chinese enterprises.

As 2010 gets underway, Geely seems set to acquire Volvo from Ford, a truly watershed event in global automotive history. Ever since China began accumulating foreign currency reserves, the question of when the country would begin to use those assets to acquire foreign brands and technology has been at the top of every investment banker’s mind. Acquiring the Volvo brand and technology is a giant step forward for Geely and China’s auto industry.

Over the past several years, China has been buying assets abroad, but to date, those purchases have been confined largely to energy and raw material companies. Concerns about the economies in developed countries and apprehension regarding the cultural challenges of managing large foreign enterprises have been major impediments for Chinese companies. The purchase of Volvo by Geely will set an important example and encourage other Chinese companies to follow suit. Moreover, the Volvo acquisition is being embraced by the international investment banking community with Goldman Sachs providing important acquisition financing.

Investment bankers are quick to pick up on new trends and mine new sources of revenues. Expect to see much more cross-border acquisition activity by Chinese industrial companies in 2010.

Prediction #4: The relationship between China and the United States will deteriorate in 2010.

As Secretary of State Hillary Clinton, Secretary of the Treasury Tim Geithner and Speaker of the House Nancy Pelosi came to China in 2009, China’s leaders watched and listened, trying to get a sense of what the Obama Administration had in mind with respect to its relationship with China. While all three spoke in grand terms of the need for a strong partnership between the United States and China in areas such as climate change, trade, North Korea and Iran, China’s leaders are from the “show me” state of Missouri and believe that actions speak louder than words.

Unfortunately, bending to the will of the United Steelworkers Union, the first action taken by the Obama Administration was to slap a tariff on tires from China. At the end of the year, the Obama Administration followed up with tariffs on steel pipe from China. So much for the importance of its relationship with China, China’s leaders must be thinking.

Protectionist trade measures, combined with China’s concerns about the value of the U.S. assets that it holds, are creating considerable tensions between the two countries. With the Obama Administration facing 10 percent unemployment in a mid-term election year, and a growing deficit and national debt, expect these tensions to increase, and the relationship between the United States and China to deteriorate in 2010.

Prediction #5: China will begin to act unilaterally on global issues like Iran.

As we discussed in Copenhagen: A Failure in Leadership, the Obama Administration failed its first real test as to whether it could effectively work with China on important global issues. By merely pushing its own agenda, not meaningfully engaging China in a discussion on climate change, insulting the Chinese with its insistence on inspections, and by acting unilaterally in Copenhagen, the United States gave China’s leaders a first-hand view of what a dialogue and partnership with the Obama Administration means. They weren’t impressed, and that is why Chinese Premier Wen Jiabao snubbed President Obama twice.

As reported in China’s Global Times, China twice refused to attend meetings when Obama was present as a protest to the U.S. demanding China accept international inspections on emissions cuts. Leaders from China, India, Brazil and South Africa were present at the meeting when Obama walked into the room without an invitation, saying “Are you ready to meet me, Mr. Premier?” The U.S. president and Secretary of State Hillary Clinton called another meeting with China, but were snubbed again when only three low-level Chinese delegates arrived. On another important global issue, the growing nuclear threat from Iran, China is again signaling its resistance to calls by the United States for sanctions.

China has already made its own bilateral deals with Russia and North Korea. Emboldened by the leadership role it played in Copenhagen, expect China to begin to act unilaterally and to address global issues in furtherance of its own agenda and that of the developing economies of the world.

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