Thursday, November 5, 2009

Rising risks of an asset bubble in China threatened by US stagflation

China and the US are dealing with their imbalances by exacerbating the very things that caused them in the first place. China entered the crisis with one of the highest rates of misallocation of investment in recent times. With its enormous liquidity released for stimulus, China with waning export markets has become a giant Ponzi scheme, with money pouring into asset speculation. US expansionary monetary policies are leading to a stagflationary environment that will pop this bubble.

Rising productivity from the build-up in infrastructure and manufacturing outsourcing, together with a policy of keeping its currency undervalued, led to massive export growth in China. The resulting dollar earnings pumped up China’s monetary system. Thanks to energy and land subsidies, cheap credit, low wage costs and lax environmental standards, Chinese state-owned enterprises (SOE's) are the primary source of their high savings rate that is financing US deficits and public debt. China has been keeping its currency undervalued to boost SOE exports by purchasing US dollars and placing the surpluses in US treasuries in a symbiotic relationship.

The SOE's surpluses in China are simply part of the transfer from household income to the state sector. The state sector ramps up investment more for policy, not profit, concerns. In the past, they ploughed this money into construction and factory investment projects that may well be already non-viable, but now they are significantly making matters worse letting the stimulus money go into massive asset speculation.

While China is experiencing weak exports now, the weak dollar allows China to release the liquidity saved up during the boom in the past five year without worrying about currency depreciation. As profitability for the businesses that serve the real economy remain weak, there has been of shift of investment into property, stock and commodity markets rather than private sector capital formation. Thus, China is experiencing a relatively weak real economy and red hot asset markets. This shift in the medium term threatens to undermine China’s financial stability.

China's corporate sector increasingly looks like a shadow banking system. It raises funds from banks, through commercial bills or the corporate bond market, and then channels the funds into the land market. The resulting land inflation underwrites corporate profitability and improves their creditworthiness in the short term. As land sales and taxes from property sales account for a big portion of local government revenues, there are powerful incentives to pump up the property market. Land sales are often carefully managed to spike up expectation through SOE's. When SOE's borrow from state owned band and give the money to local governments at land auctions, why should the prices be meaningful? The money circulates within the big government pocket. Tomorrow’s non-performing loans, if land prices collapse, are just today’s fiscal revenues. If private developers follow the SOEs to chase the skyrocketing land market, they could be committing suicide.

China's imports this year have been mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China's army of speculators is driving up prices, making their expectations self-fulfilling in the short term.

The US is trying to reflate by massive government bail outs and stimulus plans that are financed by high deficits and rising public debt levels. The FED has embarked on an aggressive expansionary monetary policy, keeping interest rates low by purchasing agency debt in order to reflate the economy and drive asset prices up. Whilst these policies are prima-facie inflationary and there will be a huge unwinding problem in the future, the low monetary velocity and slack economic conditions counter balance any immediate risk. There is, however, a growing carry trade borrowing in US dollars at ZIRP and leveraging this wall of liquidity into more risky assets such as stocks and commodities.

Monetary stimulus is considered an effective tool to soften the economic cycle. It works by inflating asset markets. By inflating risk asset valuation, it leads to more demand for debt that turns into demand growth. In other words, monetary policy works by creating asset bubbles.  In this crisis, household and business sectors in the US have not been increasing indebtedness; falling property and stock prices have diminished their equity capital for supporting debt. The public sector has rapidly ramped up debt to support failing financial institutions and increase government spending to cushion the economic downturn.

US households cannot continue leveraging up to absorb the excess production that Chinese companies  have invested in additional capacity to export. The recent rise in US personal consumption was accompanied by a 3.4% decline in household disposable income. If US household income declines, and this is likely to continue as unemployment rises even further, it is hard to imagine that US households are really going to splurge on new consumption. So in spite of temporarily good consumption numbers, there probably has been no sustainable increase in US consumption, just in government financed spending.

Regardless what central banks say and do, the world will be awash in a lot more money after the crisis than before -- money that will lead to inflation. Even though all central banks talk about being tough on inflation now, they are unlikely to act tough.

The global economy is cruising toward mild stagflation with a 2 percent growth rate and 4 percent inflation rate. This scenario is the best that the central banks can hope to achieve; it combines an acceptable combination of financial stability, growth and inflation. This equilibrium is balanced on a pinhead, requiring central banks constantly to manage expectations. The world could easily fall into hyperinflation or deflation if one major central bank makes a significant mistake.

With rising inflation expectations, should the US Fed be compelled to raise significantly interest rates in an effort of soak up the excess liquidity created by its vastly expanded balance sheet: this would be the worst possible situation: a strong dollar and a weak US economy. China’s asset markets and the economy would almost surely go into a hard landing. It would reverse the US - China symbiosis.

The Chinese would face a serious financial crisis where their overinvestment and misallocation of resources comes finally to roost with a rash of non-performing loans that would threaten their banking system with permanent loss of capital. The US would risk being caught in a conundrum with sky-rocketing interest expense on its high level of public debt resulting in ever larger fiscal deficits and there would be a drying up of Chinese surpluses to finance the deficits.

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