China Must Stimulate Economy Or Risk Political Unrest.

The Financial Times last week reads: “The benchmark one-year lending rate was cut by 27 basis points to 5.31 per cent, while the one-year deposit rate was lowered by the same amount to 2.25 per cent.”

That’s not surprising news, plus it shows some originality - China doesn’t want to end up like the US. So it cut interest rates in a multiple of 27 basis points, not in boring multiples of 25 basis points.

“The government estimates more than 10m migrant workers have lost their jobs so far, while 6.5m university students will enter the workforce next year.”

China is unlikely to escape the fate of developing countries, and facing higher unemployment, a question is raised: Will this lead to political unrest? High unemployment in China is very different than high unemployment in the US or Europe. Unlike in the developed world, there isn't much of a social net in China.

If you lose your job in the U.S, you may be forced to shop at Wal-Mart (WMT) instead of Target (TGT) and downgrade to basic cable (only 50 channels, sorry). Of course I'm oversimplifying, but the point is in the U.S, they have unemployment benefits and many other government programs aimed at keeping the Yanks from starving. This isn't the case in China.

As China's social net is in its infancy, high unemployment in many cases may mean hunger and, ultimately, political unrest. The Chinese government knows this well. Unless it comes up with social net very quickly, it will need to stimulate the hell out of its economy - far beyond the stimulus announced to date. This means more government spending. But the next bit of news I read revealed that doing so would be difficult:

“China's foreign exchange reserves, the largest in the world, apparently fell in October for the first time in five years, according to an official from the State Administration of Foreign Exchange.”

Published economic numbers are likely not describing the true economic reality in China, as -- despite economic growth for the first time in a long time -- the country feels the need to dip into its piggy bank. But here’s the scary part: That piggy bank is filled with US dollars! The U.S. government is printing a lot of money at the moment to deal with its own problems. It may or may not be inflationary in the short term (although definitely in the long term), as the velocity of money seems to be declining at a fast rate. Banks are barely lending and consumers are deleveraging and are reluctant to borrow.

But if the Chinese economy continues to deteriorate -- a likely scenario as the deterioration just started -- the Chinese government will need to start digging into its US reserves. And since there are no other natural buyers (in size) of the US debt, U.S. interest rates may actually shoot up while the US dollar crashes.

This creates a twofold problem for China: High interest rates mean even lower economic growth in the US, and even less consumption of Chinese-made goods. China can't afford a weak US dollar; that would mean its US dollar reserves will be worth even less while its products become move expensive for US consumers.

Here’s one last thought: All this is taking place while 30-year government bonds are at one of their lowest rates ever. US government bonds are likely the most overpriced asset in the world, period!