China would do better if it liberalized its capital account while simultaneously allowed its currency to float although gains from liberalizing its capital account outweigh free-floating currency gains says San Francisco’s Fed paper.

“The last option, that is, combining an open capital account with a floating exchange rate, best weathers a foreign interest rate shock. Most of the benefits stem from liberalizing the capital account. With an open capital account, the central bank does not need to sterilize purchases of foreign capital inflows,” say the authors of the Fed’s Economic Letter.

China currently imposes capital controls on its people, meaning Chinese who make foreign currency by exporting things have to surrender that currency to the central bank (PBOC) and the c.bank, in turn, stores this foreign currency cash in things like US Treasuries.

When many Chinese exporters surrender their dollars to PBOC they get yuan so in order to offset this increase in the money supply of yuan, PBOC issues domestic bonds at a specified interest rate in order to mop-up that newly printed cash. This process is called sterilization.

However, since 2008 when US rates have dropped to near zero, China has been whining about it because the US paper that they are holding is earning them less interest while the rate they have to pay on sterilization has gone up to offset inflation (see chart above).

“Thus, the 2011 current account surplus, equaling a net inflow of $360 billion, translated into an estimated net PBOC loss of over $10 billion,” says the Fed.

As sterilization costs increased, PBOC did less of it and instead let the money supply increase.

“Expanding the money supply boosts real economic activity in the short run. But it also causes inflation to tick up. That is what China experienced in the years immediately following the global financial crisis,” says the Fed.

Hence we see bubbles in things like houses.

To eliminate the sterilization costs, Fed says China can either (1) keep its yuan pegged but free up capital account or (2) float the yuan and keep capital controls.

First option would kill the inflation but would tank the GDP and drop the yuan more. Second option makes yuan more expensive at the cost of exports.

“Overall, these results suggest that China would benefit more from liberalizing its capital account than from letting its exchange rate float… additional stability that comes from also allowing the exchange rate to float appears modest.”

Survey of private factory managers by the HSBC Purchasing Managers’ Survey rose to 50.5 in November fro the shrinking 49.5 in OCtober.

The official PMI survey of China’s non-manufacturing sectors also ticked up, to 55.6 in November from 55.5 in October.

For some, these readings definitively confirm that China has bottomed and going forward, with the new political regime in power now, expansionary policies will crank up growth.

The problem that others see, besides claims that these numbers are cooked-up, is that much of this PMI growth is based on state-investment.

“The improving numbers [in PMI] are mostly  because of government investment. From the second quarter the government has unleashed a lot of projects, and that has started to be felt in the economy, but it’s not a very healthy recovery yet,” said Dong Xian’an, economist with Peking First Advisory.

Others think that state-led investment is the old trick which may not work to achieve the proclaimed reform goal of a consumption-led economy.

“Whilst we feel that the economy has been stabilized through the short-term, we feel that the manner in which activity has been revived will retard China’s economic reform agenda and make the transition onto a sustainable footing all the more tricky,” wrote Xianfang Ren and Alistair Thornton of IHS Global Insight.

At issue, in the long-term is the effectiveness of this new, higher investment, a problem eastern European countries experience during communism – an ever increasing investment yields a decreasing GDP growth.

“Production can continue (hence contributing to GDP), and employment can remain tight. Our fear, therefore, is that whilst activity is resuming, economic efficiency is declining. This has negative longer-term consequences,” IHS says.

The HSBC flash China manufacturing purchasing managers index (PMI) clocked at 50.4 in November versus 49.5 in October.

China’s manufacturing output index also rose to 51.3 from 48.2 points previously.

Anything above 50 is growth so this reading of the HSBC’s index sets the stage for a more robust official PMI release later.

HSBC PMI is weighted more towards smaller enterprises versus the official Chinese PMI which favors large state firms.

As a result, the government PMI is often a much stronger number so in this case the official Chinese PMI, which comes out one week after HSBC, will most likely show a much more robust growth.

This reading should give a boost to the commodities and the Australian dollar.

“If the Aussie dollar does indeed trend higher in line with higher demand and prices of raw materials, then there is no issue, that’s what the currency is expected to do. But if the Aussie rises further and faster than commodity prices then it represents a tightening of policy settings. So it seems another coin toss whether the Reserve Bank cuts rates in December or holds off until the new year,” says Commonwealth Securities chief economist Craig James said.

While Chinese economic growth is expected to slow the slowdown will not be crash-landing but a more moderate deceleration in growth associated with middle-income trap in some regions that is offset by regions that are less developed.

“China’s relatively undeveloped areas may be able to grow at high rates for some time before reaching income levels associated with slowdown. This could delay a middle-income trap growth slowdown for the nation as a whole,” says the Fed in its latest Economic Letter.

Authors split up Chinese data in the less developed western regions and the more developed, middle income, eastern regions and conclude that the less developed area will continue to grow at an above 7.5% clip and so offsetting the middle-income trap in the east.

Middle-income trap is  situation where the per capita income approaches middle class level so as to make the labor intensive growth model no longer viable.

Research shows that at or near $17,000 of per capita income the middle-income trap kicks in.

In case of the Asian economies, including China, this level is little lower.

“Interestingly, the middle-income trap appears to arise in Asia at lower income levels than has been found for broader groups of emerging-market economies. It may be that large Asian countries with relatively low prevailing wages cause the dynamic of the middle-income trap to shift,” note the authors.

“For example, by 2020, growth in the developed provinces is expected to slow to a still-healthy, but unexceptional 5.5%. But growth in the emerging provinces is expected to remain a robust 7.5%. Thus, China’s overall growth slowdown may not be severe,” says the Fed.

China’s data on exports are sparking a belief that China’s stimulus efforts are taking hold while data on inflation is seen as providing more room on easing the monetary policy.

Chinese customs data showed exports in September grew 9.9% from a year earlier, about twice the 5% rate expected and up sharply above from the 2.7% annual rise in August.

Consumer price inflation in September reached a new low of 1.9% while producer prices were at 3.6%,  slowest pace in two years.

“Muted inflation pressure will provide more room for the government to introduce additional policy easing or stimulus measures,” says Lu Ting, chief China economist at Bank of America Corp. in Hong Kong.

China is set to report its GDP figures later this week.

Last week, IMF said that Chinese “hard landing is a low probability” but many are looking at China and the emerging markets as a potential source of a third financial meltdown.

Morgan Stanley says that the emerging markets need to rethink export-reliant growth models and pivot to domestic drivers.