Merk Insights provide the Merk Perspective on currencies, global imbalances, the trade deficit, the socio-economic impact of the U.S. administration's policies and more.

In a housing downturn, real estate developers may go bust; banks will face non-performing loans; and workers will lose their job. With regard to banks, China has the resources to act swiftly to bolster any banks should the government choose to do so. A drop in construction related jobs would have an impact on GDP, but while migrant workers working in the construction industry may earn much more than the average farmer, their income is a fraction of that of urban residents. As such, the drag caused by a housing bust in China on consumer spending may be limited.

To understand where consumption may be heading, one must look beyond housing. Notably, with government statistics not at the standards of most developed countries, a recent study concluded that household consumption may be underreported by as much as 20%, leading to a potential underestimation of GDP by 10%. China is already the world's largest market for automobiles and internet use, as well as the second largest market for luxury goods.

Despite the State trying to micro-manage economic growth, China is said to be more capitalist than most Western countries these days. Differently said, despite government attempts to manage prices and bank lending, amongst others, Chinese businesses find plenty of ways around restrictions. We see these dynamics showing up in data such as inflation metrics that are stubbornly high, and a substantial amount of spending, notably on luxury goods, that appears to be under-reported. In many ways, the ineffectuality of China's government is a good thing. Imagine that the government was more effective in controlling prices and credit: you'd end up with a Soviet Union-style economy, where tight government control that actually works leads to empty shelves and shortages of all sorts of goods and services. Not in China.

But Chinese policy makers are keenly aware of the dangers of runaway growth, notably inflation. From the price of food to the price of luxury goods, living costs have become expensive in China. It's the inevitable result of rapidly "moving up the value chain" in the types of goods and services produced. As Chinese policy makers have come to the realization that administrative tools are not very effective in containing inflation, they have embraced currency appreciation as a tool to tame domestic inflationary pressures. A stronger Chinese renminbi will also serve as another catalyst for the rapid transformation of the Chinese economy towards a greater focus on domestic consumption. For an in-depth look at how the upcoming leadership transition in China may affect policies, please read our White Paper: China's Leadership Transition: Social Stability May Require a Stronger Renminbi

Don't count China out as an exporter as the renminbi strengthens. Indeed, we believe that China increasingly has pricing power and may be able to pass on its increasingly higher cost of doing business. American businesses are outsourcing ever more complex processes: China is best positioned to attract these projects; the more complex a process, the more pricing power the provider of such services may have.

Many Chinese businesses will undoubtedly fail in such an environment. But also consider how competitive the surviving businesses must be, having had to compete in an environment where some businesses were kept afloat through an artificially weak currency. Those that compete profitably within China may be well placed to compete with the rest of the world.

In summary, Chinese consumer spending is likely to have been under-reported for some time; we don't think a housing bust in China will stifle consumer spending as much as some fear. Importantly, Chinese consumer spending may rise like an avalanche in years to come. China is right to prepare its economy for this rise, amongst others, by unshackling the renminbi. A currency serves as a natural valve for domestic policies, helping to tame inflationary pressures. Currencies of the more developed Asian neighbors may also benefit in the process