As readers are aware, some U.S. politicians and market strategists are pushing hard to put more pressure on China for appreciating its currency. Many economists have blamed the undervalued Chinese Yuan for the huge trade deficit in the U.S., and have called for an immediate and substantial appreciation of the Yuan to fix the imbalances in the world economy.

The problem with the above views is that they fail to fully appreciate the growth dynamic of the world economy, and the very grave possibility that a sharp appreciation of the Chinese Yuan may lead to a disaster for the Chinese economy, and even the world economy.

Now in our view there is nothing in this paper that is designed to hype the condition that exists presently in global capital markets, but we are not mincing words either.

The history of the postwar world economy has been a history of all other countries chasing after the relatively wealthy and free-spending U.S. consumer. To grow their economies, these nations had to export to the U.S. as much as they could, for exchange of precious hard currency U.S. dollars. Holding U.S. dollar reserves gave these exporting countries the purchasing power to buy back advanced equipment, and therefore the chance to upgrade their domestic labor productivity.

More importantly, through the process of building an export-oriented economy, developing countries were able to structure their domestic industry in a way that maximized any comparative advantage, because these nations were fully aware that competition in global markets was essential to long-run economic health and peace amongst its people.

Over the years, this dynamic process has been repeating itself in different regions in the world: Europe in the 50's, Japan in the 60's, Asian dragons in the 70's, Southeast Asian countries in the 80's, and China since the 90's.

The economic revolution currently taking place in China has great significance to the whole world. There are presently 1.3 billion people, which is three times the total of Western Europe and four times that of USA-Canada, going through the process of modernization at a scale that is unprecedented in human history. The result is not only a higher living standard for one-fifth of the total global population, but also enormous improvements and additions to the rest of the world's economy.

However, for China to sustain its economic revolution, there are several conditions to meet:

First, there is the required high rate of investment in China's domestic economy. A high savings rate, which is a natural attribute of East Asian societies, has been a great support to the high investment rate, but it is not enough. China's trade surplus with the U.S., and related capital inflows, has also played a critical role in funding the required investments.

Secondly, the producing capacity created by these investments must find markets for their products. China's domestic market is still underdeveloped and not nearly big enough to absorb the nation's rapidly growing producing capacity. It is in the U.S. that China finds the largest and highest quality markets for its producing capacity, and it has done so with help from a relatively cheap Chinese Yuan.

Thirdly, for the U.S. to maintain its strong ability to import, the U.S. economy has to offer the best investment returns in the world, which in turn ensures that the huge U.S. trade deficit can be continuously financed by foreign investments in U.S. assets (securities, corporations and real estate).

Since the 90's, all three conditions have existed in support of both China and U.S. policy objectives. It is fair enough to say even that in the past decade the interaction between U.S. and China trade, finance and investment has been the major driving force in evolving the world economic order; while Europe, Japan, and other Asian economies have all taken only minor roles in this process.

The key to the process has been the stability of the Chinese Yuan, which was accomplished by pegging it to the U.S. dollar. In our view, both the Chinese and U.S. economies will feel significant negative impact if stability of the Yuan is no longer maintained.

The immediate hit by a large appreciation of the Yuan will be particularly hard on both Chinese and U.S. economies at this time when both have just gone through their turning point (peak of an economic cycle). China will be the first one to feel the hit.

Last year, China's GDP growth reached +9.5% Y/Y, an achievement mostly driven by two factors: exports, and a record high growth rate in fixed capital expenditure. But these came with a price: the nation's deteriorating financial system.

Banking and credit in China is not as strong as many foreigners and Chinese believe.

For many years the Chinese government, like other governments in the region, has been putting off a real reform of its domestic banking system; however, as a result of easy credit, there has been a rush almost everywhere in China to invest, especially in corporations and real estate. Unfortunately the high capital expenditure rate does not necessarily lead to satisfactory investment returns, particularly with respect to an agent problem prevailing in the China state-owned enterprises (i.e., government-appointed executives do not always put company shareholders' interest first).

There has been a staggering 30 percent or higher bad loan ratio in the state-owned banks. Even worse, while the rush to invest has an effect to magnify the GDP growth in the expansion periods, it also leads during recessions to overcapacity in most industries, which puts the nation's economy into great danger.

So, in our view, China's high capital expenditure rate coupled with a low investment return has created a massive economic bubble, and intensified the need for banking reform. Many indicators, in fact, point to the conclusion that, in the near future, the Chinese economy may begin to feel real pain.

China's real estate market has been unbelievably hot for the past few years (one of the many signs of the nation's rush to invest), as you know, but the recent data has shown a sign of cooling down in that market.

We also have reason to believe that the real estate market in China will not be the only sector that may fall into trouble. In two or three years, China's general economy may also face a severe test.

If China's economic growth slows down too quickly, a very large portion of the bank loans made during the expansion period will turn into record high bad debts, which would put the nation's entire financial and capital market system in jeopardy.

This overwhelming challenge is not good news for Chinese banks " which are not strong to begin with. At a time when the Chinese economy is facing these potentially fatal problems from inside, a large appreciation of the Chinese Yuan in international forex markets would become the last straw on its back.

China's export growth is already slowing down because of a weak U.S. economy. The sudden appreciation of the Chinese Yuan would badly hurt China's export competitiveness, eventually leading its economy into a recession. If this really happens, we will indeed see a sudden depreciation, not appreciation of the Chinese Yuan.

To U.S. interests, there is more harm than good in an appreciation of currencies of emerging economies. The decades long strong U.S. dollar policy has enabled the U.S. consumer to enjoy the benefits of rapid economic growth in developing countries, because the U.S. investment and trading houses have been using overvalued dollars to purchase foreign assets and products cheaply.

Wal-Mart (NYSE: WMT) and the under-valued Chinese Yuan is a case in point.

The more goods that the U.S. imports from emerging economies, the more that real values are transferred from those exporting countries to the U.S. household. In this scenario, the decreasing saving ratios, trade deficits, and large borrowings all make sense to Americans.

Are there concerns regarding the huge trade deficits of the U.S.? Yes, but no need to worry about them because those deficits are financed by large investments in the U.S. capital markets by China, Japan, Taiwan, OPEC producers and other emerging economies having a current trade surplus.

In fact, it is the combined effects of cheap Chinese products and large holdings of U.S. government bonds by China and other countries that has enabled the U.S. markets and Administration to keep both domestic inflation and interest rates so low in recent years. All these conditions are going to change if the Chinese Yuan appreciates significantly.

The result would be that: the U.S. would soon face the threat of inflation, as new U.S. money would have to be printed; the prices of U.S. government bonds would drop, and loan interest rates go up sharply; and ultimately the U.S. economy would go into recession -- one that could have been avoided.

These difficulties could never be justified by a relatively few job additions to the U.S. manufacturing industry in the short-run.

With all that said, however, it is also unwise for China to do nothing to adjust its currency policy or work on reform of its banking sector. The pressures from the U.S. and Europe are heating up and political rhetoric could soon lead to a large-scale trade war.

A more flexible currency system is worthy of immediate consideration. That point was made this week in important speeches delivered in China by the Governor of the Bank of Canada. He also stated that global forex imbalances must be resolved over the period of time it reasonably takes to do that, and that the long-term stability of the Chinese Yuan must not be sacrificed.

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Please send comments to: BCara@BillCara.com. In addition to this overview opinion report on China, Bill Cara, Edward Liu and Frank Liu, together plan to publish a series of detailed investment and macro-economic reports on China. These reports will be summarized in the Bill Cara Blog, and will also be presented in Chinese.

Edward Liu co-authored this report. He is a PhD Candidate in Economics at Peking University (Beijing), where he holds a Masters of Economics (1993). He was awarded the CFA Level designation June 2005. He served as Research Director, Capital & Finance Research Institute " Chengdu, China (1993-1995), and CEO, Chengdu China West Investment Co. " Chengdu, China (1995-2000). In Canada he became chief editor of a large Chinese newspaper and website company (2000-2004), and in February 2004, started his own company, RiskFile Investment Research, where he is a specialist in econometrics. He can be contacted at Edward@riskfile.com

Frank Liu also contributed to this report. He holds a CFA charter and an MBA degree. Originally from Beijing, China, Frank works as a business and investment consultant in Vancouver, Canada. He can be contacted at FrankLiuMail@hotmail.com