China has had more than its fair share of downs over the past century, but in 2011 begins to demonstrate its potential as the world’s next leading economy. Soon to boast a larger middle-class than the West and with that the promise of vastly increased consumption,n the Yuan will be a critical global currency by 2020. As long as the RMB can avoid issues of government mismanagement, inflation and real estate bubbling its potential should be realized within our lifetimes.

The rise of the Chinese Yuan as the next reserve currency and its upward revaluation have become major topics in the discourse of today’s leading global economists and finance professionals. Yet, how likely is this to occur in the next decade? Is the Chinese Yuan better positioned than the US Dollar? Is this the biggest opportunity of our lifetime or a bubble itching to burst?

Most people would agree that any type of revaluation of the Chinese Yuan or its potential reserve currency status must come with other developments, such as a stable political system, the protection of individual property rights, the liquidity of assets, real growth in the economy, and employment security. Basically, it’s everything that breeds confidence and conviction. Yet how do these things measure up in China? Over the next few lines, I will try to present an overview of some of the more pressing obstacles in the Yuan’s way of becoming the next reserve currency.

Carbs: The Metric of Life

Those in the West may shun the evil food group that populates the bottom of the pyramid, but people in China still mostly survive on noodles, rice, and bread. The cheapest and most filling of foods, carbohydrates are the keys to the survival of the Chinese masses and a great promoter of peace among the poorest. People are willing to work hard and are content with the government when they are rewarded with plenty of food. However, driven by shortages and rampant inflation, food prices have quadrupled over the last three years. The worker class is seeing more and more of its wages going back to basic livelihood needs. Sparks of unrest and discontent, such as the truckers’ strike along the Southern coastline and Honhai’s suicidal worker incidents, are perking up. Although the government is implementing subsidies and mandating wage increases, these maneuvers cannot overcome inflation. Moreover, the majority of the lower classes- farmers and factory workers- will never feel these effects. A look back at 1949 would show you that the unfed worker masses of China don’t lend themselves well to the word “stability”. Nor does the printing of money to chase ever-higher food prices bode well for a positive revaluation of the currency.

Legality: The Great Mirage

Though some may argue otherwise, no meaningful constitution exists in China. The party administration has the ability to change the laws at any time and the judges in the courts are all seasoned political appointees with little or no legal background.  Looking at the cases of recent large corporation IP disputes in China, one realizes that the Chinese legal structure can’t even protect the rights of a large corporation like GE, let alone those of millions of common people who hold their fiat money in reserve or for investment.

On the convertibility note, the Chinese cannot allow the Yuan to become freely convertible if they hope to maintain their current control on the exchange rate. Historically, the driving force of China’s growth has come from the government’s ability to centralize authority and resources, and apply them towards unified goals at whatever pace or price they desired. By allowing full convertibility of the Yuan, the government will be relinquishing most of this power to the free market’s whims and call into question the sustainability of the growth rate China currently enjoys. Yet without a free-market based convertibility, the Yuan will never become a reserve currency. This leads us back to the question of the chicken and the egg.  Which one comes first?

Labor and the Lost Generation of Brains

On the jobs front, China faces a much bigger problem than the terrible but localized incidents of suicidal Honhai workers. What China faces is the utter waste of hundreds of thousands of brilliant, educated minds every year.

For nearly 30 years, China’s growth has been driven by infrastructure development, product based, low-tech manufacturing, and exporting – none of which require the services of the hundreds of thousands of highly trained college graduates that Chinese universities are producing at growing rates. This mismatch of supply and demand has led many graduates to unemployment or to menial jobs that pay less than the wage of an average factory worker. The lack of job security and the lack of incentive for higher education are fostering a negative future outlook and complacency amongst the working masses, and can only escalate with time if these issues aren’t adequately addressed. Without a proactive workforce, the future growth and advancement of the Chinese economy are called into question.  

Real Estate Lending and Infrastructure Problems

Another aspect that will put downward pressure on and increase uncertainty in the Yuan is the inflation driven by real estate speculation and the problematic lending policies of Chinese banks over the last four to five years.

In a move to avert a recession and maintain growth rates both before and during the Global Financial Crisis, the Chinese Central Bank loosened its lending standards to synthetically create demand for factories and workers through domestic projects. However, much of this backfired through egregious misappropriation of the funds and subsequent speculation and over-construction. Like the abandoned maglev train between Shanghai and Hangzhou, many useless infrastructure projects were undertaken. Entire cities like Ordos were built in the middle of nowhere to provide jobs. The biggest problem is that much of this bad lending gave municipal governments and businesses the ability to speculate in the real estate market and engage in activities outside of their core competencies. Many companies and cities, flushed with cheap credit, dove headfirst into the one investment asset that they always perceived would go up. In their minds, it made no sense for them to work hard and reinvest the money into their businesses for 20% returns when they could get 40% from buying a piece of land right next door. This move and this mentality pumped real estate prices to astronomical levels and brought on the inflationary problems we see today.

The recent moves by the government to curb lending and restrict real estate prices don’t seem like a great solution to this problem. An interesting example of this was when Zhang Jindong, the Chairman of Suning Appliances, one of the largest electronics retailers in China, made the statement at this year’s Wharton China Business Forum that nearly 50% of their profits come from real estate appreciation. If even the largest businesses in China are so reliant on real estate gains to support their earnings, can the Chinese government afford to feasibly restrict real estate prices -and in doing so ,possibly cripple the “on paper value” growth of their businesses? Similarly, municipal governments also derive a significant portion of their budgets from their real estate earnings and would possibly be left bankrupt if the real estate markets stopped going up.

Chinese Foreign Exchange Reserves

Northwestern University’s Professor Victor Shih has estimated that Chinese local governments will borrow up to $5.8 trillion US dollars by the end of 2011 or 96% of the 2011 year-end Chinese GDP.  He also predicts that there will be an increase in non-performing loans ratio from the municipal borrowers up to 35-45% and that the government will have to recapitalize the banking system using most of its foreign currency reserves. That’s at least $2tr of bad loans the Chinese government will have to clean out.

Now this brings me to a troubling question, what exactly are China’s foreign currency reserves and who do they actually belong to? The Chinese government and leading Chinese economists have made many statements about the value of their foreign currency holdings and their ability to promote stability in the economy using the strength of these reserves. Yet, assuming that these reserves are accumulated by exchanging freshly printed Yuan for the US Dollar from the Chinese exporting companies, the value of these reserves would already be priced within the economy. Therefore, the use of the foreign currency reserves directly to recapitalize or repurchase any assets from the banks is just double-counting the same money. That is also essentially the same strategy that the US Federal Reserve used, i.e. printing paper money to spend and inflating its way out of trouble. The issue then is whether the Chinese are sophisticated enough to run a QE2-esque operation better than their American counterparts and maintain a stable economy long enough to give its people confidence in the long-term value of the Yuan.  

Conclusion

These are all critical concerns for China and for the Chinese Yuan moving forward and they absolutely must be addressed for the prosperity of China to continue. Yet despite these issues on the horizon, I am personally long-term bullish on the growth and development of China and am confident that China will continue to increase its dominance in the global arena both economically and politically in the decades to come. With a booming, increasingly wealthy middle class that will eclipse that of the US and Europe by 2020 and with a future as the world’s leading consumer, China represents the opportunity of a lifetime for our generation and, like the United States in the 20^th century, has the potential to become the next global superpower, even with some speed-bumps (five depressions, two world wars and Civil Rights Movement, among many other events) along the way.

Disclosure: As an investor whose modus operandi is to invest in the long run and stay solvent in the short run, I believe these aforementioned points are integral factors to contemplate for people interested in understanding the short-run obstacles and opportunities that China presents.