In a 1962 letter to President Kennedy, the towering economist (and, at that time, Ambassador to India) John Kenneth Galbraith counseled that “Politics is not the art of the possible. It consists in choosing between the disastrous and the unpalatable.” Chinese policy makers today face a similar dilemma, needing to choose between a (in all likelihood) disastrous stay-the-course currency policy and an unpalatable dramatic appreciation of the RMB. Regrettably, they appear almost certain to select the former strategy, thereby helping to perpetuate the unprecedented external imbalances that constitute such a grave risk to global markets.

The disastrous option features a stay-the-course policy under which Beijing prohibits rapid RMB appreciation, even though, by most estimates, the RMB is at least 25% undervalued on a real effective exchange rate (REER) basis. This implies no improvement in the imbalances represented by its enormous and unsustainable trade surplus and capital flows. China’s current account (CA) surplus has averaged an eye-popping 8.7% of GDP over the last four years and its FX reserves are forecast to top a mind-boggling $3 trillion in 2011.

Even though China is the world’s fastest growing major economy, its REER declined by 6.9% in 2009 ytd and is no higher than it was in late-1997 (when China’s real GDP was only 26% of today’s level). Keeping the USD overvalued, especially against Asian ex-Japan (AxJ) currencies, is undermining the dollars indispensable role in reducing America’s CA to a more balanced and sustainable level.

 A second problem is that protectionist sentiment continues to rise with every G4 manufacturing job lost (2.7 million in the US alone over the last five years). The University of Chicago’s Robert Aliber criticises China’s “beggar-thy-neighbor” policy in importing jobs, arguing that the RMB’s undervaluation is equivalent to a 50% import tariff. To retaliate he recommends the US implement a unilateral tariff on Chinese imports (citing President Nixon’s success with a similar policy in 1971). With China now the world’s #1 exporter, the FT’s Martin Wolf insists that, without a dramatic RMB adjustment, protectionism is inevitable, “We are watching a slow-motion train wreck. We must stop it before it is too late.”

The unpalatable option, by contrast, features a substantial RMB appreciation, which would deal a serious blow to China’s industrialization strategy. Dani Rodrik of Harvard University contends that “an appreciation of 25% would reduce China’s growth by somewhat more than two percentage points.” Inducing such a slowdown would place growth below the 8% threshold widely believed to be necessary to avert social strife. China’s Ministry of Human Resources asserts that “Achieving the 8% economic growth target is essential for expanding employment because each percentage point growth can create 800,000 to one million jobs.” This is crucial because, even though the overall population growth rate is only 0.6%, the urban labour force of 479 million is growing by just over 3% a year, requiring massive employment growth to prevent rising unemployment and social instability.

Two additional factors favour the stay-the-course approach. First, China’s industrialization strategy has been modeled on the experiences of Japan and Korea. According to Stanley Fischer, currently Governor of the Bank of Israel, their currencies appreciated dramatically once their per capita income reached 15% of America’s. This threshold was hit by Japan in 1950 and Korea in 1965, and in the subsequent three decades their REERs roughly doubled and then doubled again. China has just crossed the historically key 15% level, and has expressed considerable apprehension about excessive RMB appreciation. In particular, Beijing worries that Japan’s malaise over the last two decades is a direct consequence of JPY strength, and has resolved not to repeat this error.

Second, there are few domestic reasons to allow a sizable RMB appreciation. The People’s Bank of China is having no difficulty sterilising the huge FX inflows. There is little upward pressure on China’s highly regulated interest rates and, besides, benchmark lending rates are now more than 750 bps below levels suggested by a conventional Taylor rule. Further, import price inflation is of little concern, with November’s CPI print coming in at 0.6% yoy (-0.7% ex-food) and consensus expecting only 2.75% in 2010.

Of much greater concern is the risk that extraordinarily loose monetary policy may fuel domestic asset bubbles. Residential and commercial property construction has risen by almost 200% yoy, while property sales have almost doubled from a year ago. Even with Beijing micro-managing construction activity and credit flows, UBS warns that “Avoiding a property bubble will not be easy.”

Consequently, dramatic RMB appreciation over the next 6 to 12 months does not appear to be in the cards unless: inflation comes roaring back (food and oil prices are the key risks); more convincing evidence of a property bubble emerges; or G4 protectionist rhetoric and tariff threats intensify.

What are the investment implications of Beijing’s likely stay-the-course strategy? First, the RMB and other Asia ex Japan currencies will remain undervalued, but should appreciate moderately (about 8% per year) and possess precious little downside risk. Second, most AxJ equity markets will probably outperform even further, given continued loose monetary policy, undervalued currencies and unchallenging valuations. Third, the post-Lehman strength in the JPY (especially against the KRW & RMB) has been the key driver of Topix underperformance, and as long as the blustery FX headwind remains in place, Japanese equities will continue to lag.

Most importantly though, Beijing’s determination to avoid a dramatic RMB appreciation reinforces a monetary and FX dis-equilibrium that perpetuates large and unsustainable external imbalances that are without precedent. The cataclysmic experience of the last two years has taught investors only too well that such situations can only end in tears, even if it is impossible to predict exactly when and how disaster eventually strikes.