How Chairman Mao must be spinning in his grave. Stepping back from the statistical noise surrounding China's trade and reserves, the great deception at the heart of China's economic policy becomes apparent. The day when the Chinese population wake up to the implications is growing closer, as last year's hot money flooding the capital account in anticipation of Yuan revaluation now turns to wholesale capital flight, such that exchange controls have recently been tightened in panic. China has subsidized exports made by its impoverished workers for rich Western consumers to a huge and longstanding degree, but implicitly via the 'crawling' currency peg. China's central bank has been forced to purchase huge volumes of dollar assets (on which it can expect an eventual loss in real terms) so China's subsidy to US consumers has been hidden in this overpayment.

The Communist technocrats at the PBOC responsible for China's huge currency reserves must continually expand their losses by purchasing more dollars to hide the costs of subsidies already granted, or the exposure of the financial losses already accrued might generate domestic outrage. There is no easy way out, short of China's central bank hiding reserve losses by engineering domestic inflation, so that its US dollar portfolio does not lose value in nominal terms. That looks a very difficult task given the scale of industrial overcapacity. Arguably the development gains were worth the financial cost of China's export support, but China's leaders are terrified of revealing the unrealised losses they are sitting on and losing their remianing legitimacy. In hindsight, it would have been better for China if it had pursued explicit export subsidies to foreign consumers, which would be more politically palatable than massive losses suddenly revealed.

China's hidden subsidies via the exchange rate and reserve accumulation relied upon complex chains of financial intermediation, which eventually could not withstand the stress. There has been a crucial and devastating change. China's continuing effort to subsidize US consumers has lost all traction; lending to the US Treasury no longer translates to increased consumption in the new environment of private sector deleveraging in America. China's covert subsidy policy has fed US financial vulnerability and has now blown up in its face, creating economic instability in China that will shock complacent foreign analysts in 2009 who still forecast high single digit GDP growth.

Meanwhile, Steven Chu, the Nobel Prize winning physicist and incoming US Energy Secretary has recently endorsed the thesis of slowing fundamental innovation as a root cause of our current crisis, which I explained a few weeks ago in Stagnating Innovation: Root Cause of this Crisis?. His view is that since the transistor we have we have run out of 'Big Tools' that act as intellectual platforms for further systemic innovation (which may partly explain the single Silicon Valley IPO in 2008 against an average of 28 annually since 1985). The YouTube link to his interview is here: http://www.youtube.com/watch?v=y-7gWsoXtUw, and this is a huge underlying issue which I expect to become widely debated in 2009.