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Must read here by Annaly Capital Management:

We don’t much trust statistics that come from China, just like we didn’t trust information that came from behind the Iron Curtain back in the Cold War days. But there’s been a lot of news from China in the past few weeks, and it has painted a picture of economic recovery and strength. At 8.7%, GDP growth was faster than expected in 2009. Production, exports and fixed-asset investment in urban areas are up 20.7%, 31.4% and 26.6%, respectively, in the first two months of 2010 versus the same year-ago period. M2 money supply grew at a 25.5% clip and consumer prices rose 2.7% in February.

Believe those numbers at your peril, haircut them as you see fit, but there is one number with regard to China that is unassailable and that makes their growth miracle possible: 6.83. The pegging of the yuan at this artificially low exchange rate is the cornerstone of the Chinese economic miracle. It is the modern-day mercantilist tool, a replacement for tariffs and taxes. In so doing, it allows the country to run an export-driven economy that competes on price, depends on foreigners’ propensity to consume, and builds up huge structural surpluses with which to keep its currency peg. It’s the Walmart of countries, the big box store and category killer that no local shopkeeper wants in his neighborhood. It is the other side of the coin from the United States and Europe at this stage in the global economic cycle – – consumer-based societies that are running huge structural deficits. Despite the obvious economic wisdom of letting the currency float, and the ample cover for doing so that the latest data provide, it is unlikely that China will significantly alter its dollar-peg policy any time soon.

This is a global macroeconomic issue, but for China it is a domestic issue: There is a labor shortage in China, and those workers want to be paid. “Migrant workers are a lot more fussy than before,” He Suwei, chairman of Hangzhou Weibang Airflow Spinning Co in Zhejiang province, told China Daily. “They don’t just talk money; they talk about working environments, holidays and other fringe benefits we have not even heard of before. Workers have more say than us now because they have a wider choice.” Workers at the factory are now being paid about $270 per month, up 40% from the beginning of the global recession. At a nearby textile mill, the owner came back from the Lunar New Year holidays to find that many of his skilled workers didn’t return to work. He reluctantly had to raise wages. “I had no choice but to raise the salaries of my less experienced workers from 750 yuan a month to 960 yuan,” said the owner, Cao Yakun. “Also, to make sure the workers who did return stayed, I boosted my skilled workers’ pay by 10 to 15 percent.”

The irony here about the exploited proletariat wanting better treatment from the bourgeoisie factory owners is historically mindboggling. All we can say to the Communist Party bureaucrats is ‘Welcome to capitalism.’ The genie is out of the bottle and you can’t put it back. You can’t raise salaries on your working class because margins are too low, you can’t raise prices to raise margins because you’ll be less competitive and you can’t let your currency float because your exports will decline and slow economic growth.

The other irony: the modern Chinese miracle would never have occurred without the US Dollar as a reserve currency. As Hugh Hendry has pointed out, for the Chinese, US Dollars were nothing less than the modern-day equivalent of the relief from a too constrictive gold standard that William Jennings Bryan decried in 1896. Imagine if back then the supply of gold had been as unlimited as dollars. The fact is, in modern economies either all trading partners of more or less equal size should be linked to a similar standard, like gold, or they should all be free floating and competing. A hybrid situation like we have now just leads to hazardous imbalances.

If history is a guide, however, economic growth and a free floating currency are not incompatible. The graph below shows the exchange rate of the Japanese yen; Japan eventually let it float and they recovered from World War II to become the second largest economy in the world. It’s only when the Bank of Japan began to sizably intervene to manage their currency that the country ended up with a lost generation of productivity. China, take note.

Click Here to Enlarge Chart

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