Has the emperor lost his clothes?

Chinese news coverage is long on international economics and short on politics. Recent stories in the Chinese daily newspapers and television about America’s economic meltdown are extremely muted when compared with the private conversations which are going on all over China.

In the papers and on the news, the reports are factual. The government has asked all financial institutions to detail their potential exposure and the papers are detailing the positions of the larger banks. There are some warnings that the extent of the situation is unknown and people should proceed with caution. Surprisingly, there has been very little finger-pointing or anti-Western comments.

Privately, confidence in the West’s ability to understand and manage its financial markets is rapidly eroding. The years of lectures by Western leaders about the need to model China’s financial and regulatory systems on Western systems is ringing a bit hollow at the moment. Comments range from, “All that stock stuff is just a rigged game run by fools and crooks,” to “The United States is squandering its good will and money by engaging in costly foreign adventures and deficit spending.”

All seem to question the economic judgment and soundness of the U.S. economy and its leaders. The latest round of interventions has been confusing at best. After being told year after year that government interference and bailouts jeopardize the efficient operation of capital markets, many see the U.S. and Europe as doing the opposite of what they preach.

One policy expert asked me what the U.S reaction would have been if China had outlawed short-selling overnight (note: China does not allow short-selling currently). I had to admit that such a sudden policy change would have elicited complaints from a number of quarters.

To many of the more cognizant, the massive intervention by the Fed stemmed the tide for now, but questions remain about how the credit crisis will affect the other “shoe” of consumer credit debt. Real income and net worth have been dropping as prices and unemployment have been rising, all of which will put a tremendous amount of stress on consumer debt. The question is, will the Fed’s intervention turn the economy around quickly enough to change the fundamental problem, which is that consumers have too much debt and no way of paying for it.

The West’s investment banks were the symbol of Western financial superiority and seemed unassailable. The collapse of Lehman Brothers and quick sales of Merrill Lynch made these operations look like houses of cards, driven more by their short-term desire for deal fees and bonuses rather than the long-term interests of their investors.

The problem is that a loss of confidence in the U.S. could end the safe harbor status which has been supporting our national debt. The U.S. Treasury Department (http://www.treas.gov/tic/ticsec.shtml) reported in July a sharp shift in private international capital, $92.9 billion, left the United States, as opposed to June when $46.8 billion was invested in U.S. securities. It is doubtful that these numbers will have gotten better in August and September.

On the public side, central banks reduced their investments from an average of $22.3 billion to $18.2 billion in July. Most significant was the change in allocation from long-term Treasury’s and corporate bonds to short-term Treasury bills. Foreign central banks also became net sellers of quasi governmental bonds like Freddie and Fannie, all of which affected liquidity and indicates our vulnerability to these types of reverse capital flows.

China, with $1.8 trillion in foreign reserves (their reserves grew at $64 million an hour during the first half of this year), has become the cash king. If China loses confidence in the United States, it could have a profound impact. The Fed’s takeover of Freddie Mac and Fannie Mae went a long way to assuring China about the willingness of the United States to take care of its interests, but the long-term psychological effect of this meltdown has yet to be determined.

Some pundits point to the fact that the Chinese economy grew by 23 percent in dollar terms last year and that some of the money will end up in the United Staes, but this is based on the assumption that the United States is regarded as a safe harbor.

The Chinese see the United States as having the most powerful national economy in the world, but it is also seen as increasingly dependent on international markets. The issue is not the economic strength of the United States, but simply the domestic markets do not seem capable by themselves of sustaining historical growth models. To China, the amount of disruption caused by domestic economic cycles is the proof of the pudding.

So what does all this mean to a SME (small or medium enterprise). If you’re looking for growth, you need to be aware of the trends, and the trends seem to be pointing at strategies that pair domestic and international growth models.

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