With the US in recession, global economic growth is ever more reliant on China. But, with inflation racing ahead, Chinese authorities must adopt new strategies to contain the political and economic consequences. With China now exporting inflation globally via higher export prices, all businesses, whether directly trading or investing in China or not, will be affected by China’s performance in 2008/09 and beyond.

China’s Magic Bullet: Can A Yuan Revaluation Restore Economic and Social Stability? evaluates the key risks to stability posed by unbalanced economic growth. In particular, we focus on the impact of inflation, which has risen from 2.8% in 2006 to 8.7% in February this year. This is stoking rising unrest in both urban and rural areas. Our principal political concern is that economic losers among the ethnic Han will copy the tactics of those in Tibet and, alongside other disgruntled minorities – including Uighur Muslims, Falong Gong supporters and democracy activists – use the Olympics to challenge the government more openly.

The authorities are aware of the political dangers, and concerns about stability remain at the heart of economic policy-making. Importantly, BMI’s analysts believe that, with double-digit economic growth required to contain unemployment, the authorities will pursue a cautious approach to currency appreciation. We present the results of our econometrically-modelled scenario test of a 10%, 15% and 20% revaluation of the yuan. With a large revaluation likely to trigger deflation and a slump in growth below 5%, we believe that caution will prevail. This will minimise, but, will not eliminate either economic or political risks (See below for further extracts from the Report).

Extracts from China’s Magic Bullet: Can A Yuan Revaluation Restore Economic and Social Stability?

Inflation expectations have become entrenched - BMI believes that China has now reached a tipping point, beyond which it will become difficult to convince consumers and investors that inflation will recede. 2008 is a crucial year. Modest currency appreciation will not substantially curtail inflation and, with most now believing that the government wishes to maintain economic growth substantially beyond its official target of 8%, there is a real danger that inflation will continue to climb.

But monetary policy risks a Chinese credit crunch – In order to combat inflation, credit growth targets have been released. But in January, credit equivalent to 22% of the entire loan quota for 2008 was released. If this data is confirmed, and if the government is serious about enforcing its guidelines, it increases the likelihood of a substantial liquidity squeeze towards the end of the year. If this transpires, the number of non-performing loans – a key side effect of loose lending practices – would escalate as broader economic growth falters. Thus, while the attention of banking analysts are turned towards the US and Europe, the risks of a Chinese-style banking crisis are steadily, but consistently, rising.

The yuan will appreciate by 9% this year – Amid uncertainty about monetary policy, the government will almost certainly allow the yuan to appreciate this year. We believe that a gradual 9% rise is the most likely scenario, but we have run a one-off 10%, 15% and 20% revaluation through our econometric model. We believe that the authorities actions are constrained and that the effects on inflation and growth mean that a 10% adjustment is the maximum that the authorities will allow.

Tibet highlights political risks – International attention is focused on Tibet. However, while a concern – not least as it provides the state’s access to Western Eurasia – the perfect storm for the authorities would be a simultaneous challenge from Tibetans, Uighur Muslims, Falun Gong supporters and democrats. In an Olympic year, the authorities will move rapidly to quell dissent, but this risks a heavy-handed public security display and an overly-cautious economy policy.