This article is a guest post by Ed Harrison of Credit Writedowns.
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China is in the midst of an asset bubble. The evidence is clear that China’s aggressive fiscal and monetary policy is causing the Chinese economy to overheat, with some predicting 12% growth for the Q1 2010. According to Marshall Auerback, researchers at Lombard Street think GDP growth hit an annualized 25% in the second half of 2009 (20% real and 5% inflation) but that the year-on-year data obscured this. Chinese policy makers are looking to rein all of this in for fear of a hard landing.
Analysts like Edward Chancellor of Grantham, Mayo, Van Otterloo & Co. LLC have written well-constructed arguments why we should be cautious, pointing to the age-old signs of a financial bubble. Nevertheless, others are making excuses.
Cait Murphy explains quite well that these excuses tend to fall into three specific camps. I will quote her below and add some extra commentary.
1. China’s asset price rises are not underpinned by debt.
About half of apartments are paid for in cash, and for those who get mortgages, the down-payment is typically 50%. Mortgage debts, which make up about 10% of Chinese GDP (compared to more than 100% in the U.S.), are not securitized and are kept on the books of the banks that issued them…
But just because China is not leveraged the way the U.S. was does not mean it is not leveraged at all. Developers, for example, take on debt to start projects and these are largely based on a calculation of future property values, which of course are assumed to always be rising….
Murphy goes on to point out that all bubbles are equal, but some bubbles are more equal than others. And this is the crux of the argument here – bubbles underpinned by debt are assumed to be damaging and ones not underpinned by debt are not. This does not sit well. Unlike former Fed member Frederic Mishkin, I believe potential asset-prices bubbles are always dangerous because of the misallocation of economic resources they induce.
However, here debt is indeed the problem. Just because property price excesses are not financed by high debt levels in the household sector doesn’t mean there isn’t a debt problem. If you recall, in Japan, it was the business sector’s property-related debt which created Japan’s balance sheet malaise. In China, the same is true again.
2. China has a huge cache of reserves
China has $2.4 trillion in reserves. As Thomas Friedman put it, with ghastly roguishness, “First, a simple rule of investing that has always served me well: Never short a country with $2 trillion in foreign currency reserves.” Having a lot of reserves does not mean there cannot be a bubble. Just two quick examples:America in the 1920s and Japan in the 1980s had reserves about the equivalent, in global GDP terms, as China does now. We know how that worked out. But if there is more supply than demand, and if prices keep going up faster than income and if there is something like hysteria about getting into the game — all characteristics of a bubble, all too true in China right now — the market is going to correct. Period.
Reserves protect the value of a currency and are good for a country’s credit; they are a force for financial stability. But they cannot prevent the formation of a bubble. If anything, huge reserves can be a symptom of underlying economic imbalances, notes Michael Pettis, a specialist in financial markets at Beijing’s Guanghua School of Management, in the form of “a too-quick expansion of domestic money and credit.”
The reserves are irrelevant. What I discussed in the links this morning regarding Argentina is highly relevant here. Argentina’s President Cristina Fernandez de Kirchner has demanded the central bank to use foreign currency reserves to pay public debt maturities. This is what people are saying the Chinese could do. But it is not as simple as that because the central bank has a balance sheet just like any other company. The reserve assets are underpinned by currency liabilities. Pettis says:
…the PBoC has a balance sheet consisting on one side of dollar assets (and here “dollar” is short-hand for all foreign assets). Against this and on the other side it has a roughly equivalent amount of RMB liabilities…
…China’s reserves are often thought of as if they were a treasure trove available for spending. They are not. They are simply the asset side of the mismatched balance sheet. If the PBoC wanted to “spend” $100, say for example to recapitalize a bank, it could do so, but this would automatically create a $100 dollar hole in its balance sheet. – it would still owe the RMB that it borrowed originally to purchase the $100…
Can PBoC reserves protect China?
So the PBoC cannot give away the reserves without causing an increase in its net indebtedness. …Beijing cannot just recapitalize the banks with reserves. A substantial amount of NPLs will one way or another increase government debt. The only way Beijing can recapitalize the banks is by borrowing, or by raising direct (or hidden) taxes. Having the PBoC recapitalize the banks is just another way for the government to borrow, and since almost everyone would agree that losses in the banking system should be paid directly out of fiscal revenues, and not indirectly by the central bank, it would be a very inefficient way of doing so.
So what are reserves good for? As long as China maintains its own currency and denominates all domestic transactions in RMB, the PBoC reserves cannot be used in China. They cannot go to pay doctors’ salaries, to build bridges, to lower taxes or to subsidize consumption. They can only be used to purchase or pay for things from outside China. This means that reserves ensure that China can import foreign commodities and other goods as long as it can pay for them domestically. It also means that the PBoC can ensure the availability of dollars to repay foreign debt and foreign investment.
So the point is that the reserves are meaningless in the context of asset bubbles.
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3. Chinese policy makers are clairvoyant
The government won’t let it happen. It’s true that the Chinese government, unencumbered by trivia like freedom, can do big, difficult stuff more readily. For example, China’s stimulus program was triple, in relative terms, that of the U.S., and because their planners did not have to deal with things like public opinion to any significant degree, lots got spent quickly. Moreover, the government owns the banks, so it should be able to exert control over them. And yes, it’s true (as noted above) that the government is aware of the problem. In fact, Beijing has done a couple of things to try to cool down the market, such as requiring banks to raise their reserves; making the purchase of second (or third or fourth…) homes more difficult; and reducing the mortgage interest discount.
So what? Animal spirits are well established already. I would argue that, once the animal spirits of an asset bubble have taken over, the central bank must go well beyond policy normalization and institute a very restrictive monetary policy to rein in excesses. This risks a hard landing. In fact, this is the very same ‘conundrum‘ Alan Greenspan faced with his baby step 25 basis point increases in the Fed Funds rate.
And I am not confident in the least that Chinese officials are any better at reining in asset bubbles. Willem Buiter and and Shen Minggao have it right.
“This time is unlikely to be different unless the authorities in China act differently from the authorities in China and elsewhere in the past,” Buiter and Shen said.
Policy makers probably won’t temper investors’ exuberance because they don’t want to lose political support or hurt the investment growth they view as necessary to ensuring the economy maintains an 8 percent growth rate and spurs employment, Citigroup said.
“Few politicians have been successful running against asset booms and bubbles,” the report said.
When the asset bubble does break, the impact will be painful for China and its trading partners, Buiter and Shen said. It may still not derail China’s economic expansion so long as the nation’s leaders seek to make the economy more reliant on domestic demand…
Sources
Yes, Virginia, China Does Have a Bubble – Cait Murphy
Citigroup’s Buiter Warns China Facing ‘Boom, Bubble and Bust’ – Business Week
Source: CreditWritedowns.com
Edward Harrison is a finance specialist at Global Macro Advisors. He was a strategy and finance executive at Deutsche Bank, Bain, and Yahoo. Edward started his career as a diplomat and speaks German, Dutch, Swedish, Spanish and French. He holds an MBA from Columbia University and a BA in economics from Dartmouth College. Edward also write the blog Credit Writedowns. Follow him on Twitter at twitter.com/edwardnh to receive all updates on finance news from around the web.
