Julius Baer in Singapore looks at recent developments in China - and the US - and concludes that China seems more likely to persist with reforms than the US will succeed in protecting a dollar-based financial system.

Editor’s note: Below
are comments from Dr Lee Boon Keng, who is head of the investment solutions group,
Singapore, at Switzerland’s Julius
Baer. The opinions expressed here are not necessarily endorsed by this
publication although we are grateful to share these with readers. Readers are
welcome to respond with comments.

While the global financial market was gripped by the ongoing
drama of the European debt crisis, the two major events in 2012 were clearly
the US presidential election
and the once-a-decade leadership transition in China. The results of these two
events will set the tone for 2013 and years to come.

In the US,
we have now a president emboldened after having been voted into office despite
a multi-decade high in the unemployment, and because this is his final term,
has nothing to lose but to push through his agenda. This will come head-to-head
with a House of Representatives dominated by Republicans loathe to appearing
weak after the humiliating defeat.

What is perhaps not so obvious to the financial market is
how to deal with a new Chinese leadership compelled to fundamentally change the
landscape of the global financial system in the years to come despite a
re-emerging US and because of a crippled Europe.

China

While the Chinese government has announced economic and
political reforms in the past, implementation has mostly fallen short because
there was no platform to judge its performance. To boot, the government had
near complete control of information which put them in an advantageous position
to massage performance whenever needed.

Today, with the internet, there are very few places to hide
and in those places, controls are slowly being peeled away by the social media.

To be sure, the Chinese government is also keenly aware of
the consequence of not changing. The “Arab Spring” is a clear wake-up call that
has not gone unnoticed and similar events must be prevented from taking place
in China
at all costs.

The need for accountable reforms in China has
reached a tipping point.

Top on the new leadership’s priority list is to
systematically narrow the widening income gap. Not doing so will plant the seed
for a social uprising that no political reforms or putting more corrupt
politicians behind bars can undo.

Basic economics tells us that growth and distribution are
opposing forces. That is, to improve distribution, some growth, not all, will
have to be sacrificed.

But which growth area in China should be sacrificed in order
to achieve to best result? Conventional wisdom points to shifting the weight
away from the tradable to the non-tradable sector of the economy. It is
probably right.

The benefits and the steps needed for a structural change
into a more domestically driven economy are well documented. What is perhaps
not so well understood are their impacts on the global financial system.

If China
is successful in turning its economy into a more domestically driven one, the
corresponding decline in foreign exchange accumulation, particularly in US
dollar, and trade would sever the key monetary linkage between China and the US. This, given the size of the
Chinese economy, will create a global financial system no longer dominated by
the US dollar.

That is, China’s
national policy imperative to create a more equitable society and maintain the
government’s legitimacy, are in conflict with a largely US dollar based global
financial system.

However, such a financial system is something that the US will not
give up easily.

Printing money

This is because without it, printing money to get out of a
financial crisis will no longer be as effective as today (think Japan)
and the gargantuan fiscal problem will finally come home to roost.

Will China
put its national interest second to the current global financial system?

Recent political posturing and efforts to make the Chinese
yuan a tradable and reserve currency suggest not. In fact, the fiscal and
monetary hole that the US
has dug itself deeper into since the global financial crisis is providing
fodder to move away from the existing financial system.

Will China
be successful in its political and economic reforms this time round?

Well, we know the Chinese government’s legitimacy is no
longer based on economic growth but accountable political and economic reforms.
We also know that in driving fundamental change, steadfastness and an
unquestioning commitment to the cause yield better results. This is not done
when a government is divided but when it is united.

Is the Chinese government more united in sustaining its
legitimacy or is the US Congress more united in maintaining the current US
dollar based global financial system?

I’d place my bet on the former.

If I’m right, these changes will take place sooner rather
than later and investors around the world must not be caught unprepared.

Do you have Chinese yuan as part of your portfolio yet?