Recently there was a test flight of the new Chinese stealth fighter. This comes on the heels of the unveiling of the new aircraft killing missile the Chinese recently showcased. Both of these programs are years ahead of schedule, according to prior estimates by US spy agencies and commercial analysts. Hmmm....

Before I get too much further into this meandering missive today, I’d like to thank the following US companies for all their help in supporting Chinese military efforts that will make it exceedingly more dangerous for the US Navy now assigned by our enlightened elite to patrol the Yellow Sea et al in the Pacific.

The Western companies working on China's C919 jet mostly through joint ventures, according to The Wall Street Journal (of course these are “commercial and not military” ventures the Western companies may argue, as they play the deer-in-the-headlights card in an attempt to justify these deals) include:

General Electric Co. - Avionics, cockpit-display systems, on-board maintenance systems and flight recorders.

Rockwell Collins Inc. - Communication, navigation and surveillance systems.

Eaton Corp. - Fuel and hydraulic systems, cockpit-panel assemblies and dimming-control system.

Hamilton Sundstrand Corp. - Electrical power systems.

Honeywell International Inc. - Flight-control systems, auxiliary-power unit, wheels and brakes.

Parker Hannifin Corp. - Hydraulics, flight-control and fuel-tank systems

This information comes from China Squeezes Foreigners for Share of Global Riches(WSJ), 28 December 2010. The gist of this story is this: Sure, westerners are heaping tons of technology to build Chinese competitors, but if company A doesn’t take the deal, company B will.

Interesting how behaviors are justified in the world of the global multinational. Morality and principle need not apply. Show me the money. Maybe that is the best way. Maybe that is the market way. But for some reason, not so deep down, there is, or should be, some angst knowing just how right Lenin was when he said:

"The Capitalists will sell us the rope with which we will hang them."

China is a growing world power. It will naturally create friction among the competing powers, especially the US, as it grows and jockeys for position. It wants more control of its space (ultimately wants to be sure it will be a layup when it retakes Taiwan). But what is interesting from an economic perspective is why China is showing its cards now?

By now I mean, up until now, China has been operating under the Deng Xiaoping 1991 dictum, “hide your strength, bide your time”.

Military advances till now have been hush-hush as China has effectively integrated lots of the free technology Western companies have shared in order to stake out a position to access the potential riches of China’s huge market, no matter they created Chinese domestic competitors as quid pro quo. (Amiable dunces, plain stupid, or so damn greedy these Western companies don’t care, or the market way as it has been and always will be? Maybe a combination of all that. No matter now, the genie is out of the bottle and he ain’t going back in anytime soon.)

But I ask why now because of China’s relatively weak economic position? OMG! Jack, how the hell can you say China’s economic position is weak? Well, several reasons:

1. Rising inflation is creating social tension
2. Bubbles permeate the landscape
3. Corporate profits appear relatively weak given all the excess capacity and redundancies
4. The economy is extremely imbalanced and highly dependent on Mr. US Consumer

Of the reasons, #4 is the key. The US consumer represents half of all global consumption. Global consumption is the stuff that utilizes Chinese exports—which are required to keep people employed and the Princelings (commie party brats and pals) flush with growing wealth and power; a shift of policy to give more to, let’s call them “regular Chinese citizens,” by building the consumer market is an affront to the wealthdriving industries controlled by Chinese government through their Princeling conduits.

So, if the military in the US perceives China’s recent build up, defined here well by The Wall Street Journal yesterday:

“Some defense analysts and Pentagon officials believe both the China stealth fighter and antiship missile are designed to limit America's ability to operate freely in the Pacific and East Asia. On Thursday, the Pentagon announced it would invest in a new generation of ship-based jamming technology, a longrange penetrating bomber, a new generation of sea-borne unmanned aircraft and improving the radar on the older F-15 fighter planes.

“Defense officials said those weapons systems could help counter weapons systems meant to prevent American access to international waters near China.”

…as threatening, as it seems they must given their mission to be the defense shield for the region, then the US still has broad headway to blunt China’s economic rise by making it more difficult for China to send its exports to US shores.

Thus, now seems an odd time for China to portray its growing military might. Have they calculated the US is too weak and bogged down too much to respond in kind, i.e. further boosting military spending to stay ahead? If so, China is very wrong here as anyone who pays attention realizes the US Military Industrial Complex ultimately drives the train in the US. Justifying further US military spending becomes a layup now that China is becoming a challenger (why we said the arms race in the Pacific is on). We expect Japan and South Korea to jump into the military build-up fray in a big way (at the insistence of the US besides the Chinese growing naval threat to the sea lanes that are vital to both S. Korea’s and Japan’s economic assistance). So is this show of military strength by China calculated to put the US dog on its back legs before China’s President Hu Jintao meets with President Barack Obama later this month?

Maybe!

From Reuters:

BEIJING, Jan 13 (Reuters) - China will cast a sceptical eye over a U.S. offer to free up trade in high-tech goods and will refuse to be drawn into a bargain to speed up appreciation of its yuan currency, Chinese government advisers and economists said on Thursday. U.S. Treasury Secretary Timothy Geithner said on Wednesday that Washington was "willing to make progress" in giving China greater access to the American market and high-tech goods, provided that it saw some give from Beijing on its tightly controlled exchange rate regime. Chinese officials declined to comment on Geithner's idea, made ahead of Chinese President Hu Jintao's visit next week to the United States, but a series of advisers and analysts said that it was unlikely to jump at a trade-for-currency deal.

"China has never thought about yuan appreciation from such a perspective," said Ding Yifan, deputy head of the World Institute in the Development Research Centre, a think-tank under the State Council, or cabinet. "The Chinese yuan will not rise in a way designed by the United States. Yuan appreciation is a general trend. It is not because the United States wants it," he said. The pilfering of U.S. intellectual property is the main reason for the curbs on exports of high-technology products that China consistently demands Washington remove. Washington may, in fact, be too slow in opening the door to American technology, said Tao Xie, an expert on U.S.-China relations at the Beijing Foreign Studies University. He noted that a parade of top Chinese officials had visited Western Europe in recent months and appeared to be making inroads there in gaining access to high-tech goods. "That means we may not need to make major concessions to Washington about the currency," he said. "If China can get the same level of technology and equipment from Western Europe, why should it bother with the United States?"

There is a lot in that little story, and it leads to lots of thoughts and fantasies. Geithner is getting more focused—the political give here is a rising yuan (the immediate impact of this can be debated till the cows come home; the fact is China has manipulated its currency to its advantage for many years). The little movements of late are “hailed” by Chinese cheerleaders to show just how flexible China really is—it’s entirely the US’ fault of course. The blame-the-US-first crowd is alive and well and gaining strength seemingly everywhere. Well, my suggestion would be to end the US defense shield everywhere—bring our troops home from Japan, Germany, Korea, Afganistan, Iraq, et al. Then let China gain hegemony. Let Russia retake Eastern Europe.

Maybe that wouldn’t happen. Maybe we would all live in peace and harmony holding hands singing peace tunes in the world where the evil US has gone away. This really is a vision that would be good for the US played out to its logical conclusion (for many reasons in my mind). China hegemony—a cold dark hell of a world that would be, and maybe if the US-being-blamed-first crowd gets their way. But, US leaving all those places won’t happen precisely because the Military Industrial Complex would never let it happen ... I digress ...

China will revalue its currency when it suits China; the way it has always been. We believe it is increasingly going to benefit China to allow its currency to rise. A stronger currency would help blunt inflation, become part and parcel to the necessary rebalancing of the economy, and placate the US politicians’ calls for trade tariffs on Chinese goods. (This is another reason why we like Asian-block currencies across the board long term.)

Pilfering of US intellectual property. This seems a canard. Let’s be sure China doesn’t counterfeit a Gucci bag or movie CD, but no problem if US companies give China all the technology they need, representing hundreds of billions in shareholder sunken R&D expense that Chinese companies won’t have to bear.

US may be too slow to opening the door to American technology. So maybe there is stuff the US won’t give them. No problem, there is always Germany and France. And why does anyone believe China’s recent foray into bond buying in the periphery countries of Europe had much to do about economics? It is about more levels of advanced technology that in fact they can’t get directly from the US that will be used to build their military. So nice that President Obama recently threw away our long-term “special relationship” with the UK to announce that now France is our “best ally.” I guess when Mr. Obama cleared the Oval Office of that nasty Winston Churchill bust, embarrassed by all the past world imperialism and pillaging, no matter all the benefits the UK bestowed upon world order and civilization (almost incalculable). But of course the politically correct way is to only see all the evil and harm the UK bestowed on those angelic native societies (there was that too no doubt). Thus, when Winston was packed up and sent back, we should have known our new staunch ally was France. I am sure they will be there in the foxhole when the time comes as the UK always has.

There are major and growing tensions across a broad range of subjects between the US and China. China’s new revelation of military power—showing they will counter the US as the major power in the Pacific will reverberate through global markets in a big way. Stay tuned—it is about to lurch from interesting to enthralling as it plays out going forward, we think.

P.S. Lately there has been a lot of press about the recent moves by the Chinese to allow for limited convertibility of the yuan. This is long overdue. The end of the dollar, say the cadre of yo-yos looking at this. Jeez Louise—get a grip!

If you are very young and live another 50 years then maybe the yuan challenges the US dollar. Our bet is that it never does. [See the November Currency Investor for a full summary as to why the yuan will not challenge the dollar for a very long time if ever.]

We think the sentiment extreme is in on China. You can play with regression analysis all you want, but it doesn’t work in the real world.

For more from Jack, visit Black Swan Capital and register for their daily newsletter, Currency Currents.