know what you're thinking about," said Tweedle-dum, "but
it isn't so, nohow." "Contrariwise," continued
Tweedle-dee, "if it was so, it might be; and if it were
so, it would be; but as it isn't, it ain't. That's
logic." - Lewis Carroll, Through the Looking
first ease the inflow [of capital], then ease the
outflow of capital, then ease the long-term capital
flows, then ease the short-term capital flows," Wei
Benhua, deputy director of China's State
Administration of Foreign Exchange was quoted as
saying by the Financial Times. That's logic!
so much desire for easing capital flows into China?
Well, the money rushing in has created a classic bubble
in the Chinese economy. Policymakers are well aware of
it. And the fact that they are now applying both sets of
brakes - administrative controls and higher interest
rates - knowing full well the potential for social
unrest if China doesn't grow, should tell us this bubble
is bigger than it appears.
Recent global bubble-ology that ended badly:
Japan property bust, 1992
Asian financial crisis, 1997
Internet/tech bust, 2000
Granted, the economic
dynamics driving each of these situations differed. But
each has one thing in common - massive liquidity created
from artificially low interest rates and the virtuous
self-reinforcing upward spiral of prices. The Chinese
bubble is part and parcel of the bubble in global
property. It's the offshoot of the US Federal Reserve
Board pushing the Fed Funds rate (ffr) down to 1% in an
effort to stave off deflation when the Internet/Tech
bubble popped. Consider it a five-year cycle of
speculative juices running amok thanks to the central
bank's magical wand of liquidity.
rates send the signal to entrepreneurs that both
resources and future demand will be available to support
new projects. Artificially low rates - the suppression
of the "natural rate" of interest - is what leads to
over-investment, excess capacity, and competition for
scarce goods, driving up prices. China's annualized
consumer price index (CPI) rose to 5.2% in September;
but it's 10% at the wholesale level.
have witnessed in China is not about efficient markets,
rational investors, or bell curves of the fairy tale
land of financial theory. It's about rank speculation on
the part of the crowd, with the People's Bank of China
and the US Federal Reserve acting in key supporting
roles as accomplices.
"The economy is not
healthy enough, wealthy enough for them. The resources
they need for completion are not available. The
resources they need must first be drawn from other
enterprises. If the means had been available, then the
credit expansion would not have been necessary to make
the new projects appear possible," writes Ludwig von
As Morgan Stanley's Andy Xie puts it:
Speculative capital poured into
China for two years as the Fed cut interest rates to 1%.
Ample liquidity triggered an investment boom that
exacerbated inflation. The resulting negative real
interest rate amplified investment demand and caused a
speculative bubble. China may have invested US$200
billion more than it should; fixed investment may be 20%
above trend. This must be brought below trend for a
period to absorb the excess.
The net wealth of US households
increased from US$42.3 trillion in 2000 to $45.2
trillion in the first quarter of 2004, within which the
real estate component increased from $12.5 trillion to
$16.6 trillion. The value of real estate increased by
31% between 2000 and 2003, compared with 13% between
1997 and 2000. Without the extra increase in real estate
value, US household wealth would have remained
However, because investment levels
are too high, return on capital in China is generally
low. Capital inflows and export income do not
automatically translate into investment.
Rising profit expectations due to
rising property prices have driven the current
As retail sales grew at 30% as fast
as investment in 2003 and 44% this year so far, meeting
consumption demand could not be the main motivation for
the current investment boom.
The bulk of the profit growth in
the current boom comes from the material, financial and
property sectors. The growth and high margin for the
first two sectors depends on the strong property demand.
Hence the profitability in this cycle depends on rapidly
growing property demand and high prices.
The total amount of property under
construction is likely to reach 1.460 billion square
meters, with a market value of about 30% of the gross
domestic product (GDP) by year-end. All data suggest
that the market is grossly overextended.
One-third of its fixed investment could
represent overshooting accumulated between 2002 and
2004. The adjustment to come could be quite painful.
As much as we would like to believe that China
represents a rip-roaring free market economy - the
implication of a fawning financial press - the fact is
that China's economy is still 50-70% centrally planned.
And we know centrally planned economies are prone to
shortages and bottlenecks. They lack the flexibility to
properly absorb and assimilate huge investment pools.
Thus they spur political corruption.
almost every investment involves a government decision,
political influence or semi-official payoff," writes
Barry Naughton, professor of Chinese and international
affairs at the University of California, San Diego, in
an open letter to Chinese Premier Wen Jiabao, in Foreign
Policy magazine. "There is no question the economy is
seriously overheated, rippling electricity shortages
cause blackouts and inflict significant economic damage.
Huge investments in real estate and popular industrial
sectors generate useless capacity that threatens to sap
the country's economic strength for years to come?.The
almost weekly scandals in the financial sector are
making investors nervous and sinking important deals,"
"Risk-taking is inseparable from
lending. Every loan, even if fully secured, is a kind of
speculation," writes Jim Grant in his book "Money of the
Mind". In China, security has played little role in
lending, it is all about speculation.
to The Economist magazine, China's banks have been
little more than conduits for pouring money into local
governments and state-owned companies, with little
regard for risk or profit. The build-up of
non-performing loans have led to insolvency of virtually
the entire banking system. By end-2003, outstanding
loans had surged to 145% of GDP, the highest such ratio
in the world. Bad debts to banks at 40% of GDP are a
threat to fiscal stability. Most Chinese bankers,
particularly in local branches, cannot tell a good loan
from a bad one. There is no need to, because local
managers' pay has depended on asset growthˇ¦Lending lots
and attracting deposits quickly have been all that
counted - risk, return and capital adequacy have meant
The magazine also notes that local
governments have illegally underwritten $100 billion in
loans to bankroll favored investment projects. And
though the Chinese are making strides and moving as fast
as they can on reform, this system will take years to
An accident waiting to happen "We have
learned quite a bit about emerging markets, and we know
that among the many characteristics is that they are
accident-prone," Moises Naim, editor of Foreign Policy
magazine, said at a recent IMF Economic Forum on China.
Not only on the financial side of the fence is there a
bubble, but there's one on the social side as well.
There are an estimated 150 million
surplus workers in the rural sector.
There are 10-12 million surplus workers
in the state-owned enterprises.
11- 12 million people are added
annually to the working-age population.
800 million rural Chinese make 15% of what their
counterparts in the cities earn," according to Naim.
That is staggering inequality. "Because the inequality
is so staggeringˇ¦and access to services and
infrastructure so uneven between rural and urban areas,
and unemployment so unevenly distributed, the burden to
argue that China will not have some growth-impairing
accident is very hard."
And as much as Chinese
policymakers understand and work to rectify the problem,
local officials often exacerbate it. "Today's economic
bubble began in 2001, when local officials initiated a
spate of construction projects to showcase their
achievements and to ease the leadership transition at
the 16th Communist Party Congress in 2002. This
"political-business cycle" accelerated as new leaders
took office and committed themselves to another round of
public and private investment projects. The abuses you
have uncovered - such as the Tieben steel mill in
Jiangsu, built with shady funding on land expropriated
from peasants - are only the worst among many
ill-advised economic interventions by local officials,"
according to Naughton.
China's hike in interest
rates marks the beginning of the end for a hard landing
of the Chinese economy. China's growth is highly
dependent on increasing amounts of capital to support
infrastructure and manufacturing projects because its
service sector is weak and domestic consumption is not a
major driver. The service sector in China is less than
35% of GDP (the lowest among any major economy in the
word). Consumption GDP was 54% of GDP (again, the lowest
in any major country).
And even the consumption
side of the economy could be heading for trouble.
Growing indebtedness of the wealthiest segment of the
Chinese society, in the face of rising prices, could
crimp demand. "The news on slowing demand is accompanied
by disturbing accounts on debt levels in some Chinese
cities. The Chinese Academy of Social Sciences just
reported the household debt to disposable income ratio
at 155% for Shanghai, 122% for Beijing, 95% for Qingdao,
91% for Hangzhou, 85% for Shenzhen, 79% for Ningbo, and
44% for Tianjin. Five years ago, household debt was
virtually zero. China's household debt has experienced
the most rapid rise the world has ever seen," according
to Morgan's Andy Xie.
The implications of a
Chinese hard landing will ripple through every major
asset market: Stocks, bonds, real estate, and
commodities. The linkage will be the blowback through
the American consumer.
From virtuous circle
China is the world supply source
America is the world demand source
China sells goods to the US consumer
The consumer sends dollars to China
China parks dollars in US bonds
Lower bond yields subsidize the US
consumer, spurring demand and investment
US consumer demand leads to investment
in Chinese manufacturing.
At the core of this virtuous circle is
credit expansion. But we know that is changing. China is
hiking rates and so is the Fed. Rising interest rates are
the feedback loop that will suppress Chinese growth and
US consumer demand. The chart at left shows US
consumer expenditures make up a whopping 70% of US GDP.
And the ramp-up in this ratio over the last three years
coincided directly with the fall in the Fed funds rate.
But it doesn't stop there. The chart at left shows that
US consumers took on high levels of debt in order to
finance this consumption binge, and the rest of the
world - primarily the Chinese and other Asian central
banks - were the major buyers of the debt, as depicted
in the lower chart (again highlighted is the surge
in consumer debt correlated with the ramp-up in debt
held outside the US).
Chinese policymakers have chosen to risk the
ravages of a hard landing before the inflationary stage
of their economy morphs into hyperinflation. Many
analysts believe China will be successful in engineering
a slowdown without going bust. They may be correct of
course. But because of massive over-investment, lack of
financial system sophistication, rigidity of a centrally
planned economy, and staggering and growing
inequalities, a hard landing seems inevitable.
The investment implications are vast. And the
opportunities on the short-side of many markets will be
exciting while they last - almost as exciting as the
potential on the long-side of many markets once China
works its way through this cyclical event. Because
ultimately, the Chinese economy will emerge even
stronger from the lessons it learns from this cycle.
It's only logical.
Jack Crooks has
actively traded in global equity, fixed income,
commodity, and currency markets for more than 20 years.
He is president of Black Swan Capital, a currency and
commodities market advisory firm - BlackSwanTrading.com.
Black Swan offers a subscription-based currency
advisory service for forex and futures
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