June 27, 2011 Leave a comment
I intended to blog about this months ago, but never had a chance to do so and thought I missed an opportunity. But with China’s real estate market still peaking, albeit recent slowdowns, the below argument is still valid.
1st argument: China is printing more cash than US or printing a tremendous amount of cash.
2nd argument: China is following US’s economic cycle, but on a much accelerated rate.
3rd argument: China is in trouble.
China is flooding itself with liquidity by printing an excessive amount of cash. I am not completely certain about the purpose of this proposition but it is plausible that the printing is done to alleviate any potential liquidity crisis, which is gradually taking form, also in the form of a real estate bubble, but probably a much more severe version with the inflation bubble fueling the level of severity. In 2008-2009, China’s interest rates remained rock solid at relatively low level of 5.31%. The low interest rate spilled over to the housing market in which consumers purchased real property like there is no tomorrow. The word on the street is that in Shanghai, if you intend to purchase a real property, do so immediately because once you hesitate, someone else would purchase that same property. Now, what caused such buying frenzy, assuming there is in fact such frenzy. Naked Capitalism recently published a document that investors have no other viable investment alternatives aside from real estate. However, I believe that easy credit is the main thrust behind this frenzy. However, one might still argue that China has imposed a multitude of measures to raise the cost of credit. Yet, all those measures, including interest rate hikes, sterilization, bank reserve requirement ratio (hereinafter, RRR), Central Bank Bills (government bonds VOLUNTARILY bought by commercial banks), credit quotas, and credit ceilings collectively accounted for less than 10% of China’s liquidity. At 10%, those measures would not even put a dent to the overall liquidity. The question becomes, what about the remainder 90%? The answer is quite simple, as I believe – a cash printing spree. Evidently, though despite that China intends to or might have already lowered the credit ceiling from $8.0 trillion to $7.5 trillion, subsequently and at least on paper, raising the cost of credit, the ratio of money supply versus GDP is still at a mind boggling 190%. For comparative purposes, I struggle to find any money supply versus GDP ratio (calibrated as M2) over 110%. The key point is, with so much liquidity, any efforts to raise to cost of credit is simply mitigated or even overcame, thus lending credence to lax lending standards, which is of course now one of the confirmed lynchpins of the financial crisis. Chinese banks are lending like there is no tomorrow. If so, then what’s next? US lent like there is no tomorrow starting in 2002 – 2003, the housing market peaked in 2006 – 2007 and the market completely collapsed by 2008. With the housing market still peaking and probably wouldn’t reach the peak until say 2014 and with the above proposition that China is on an accelerated US economic cycle, we might see a complete collapse by 2015 or 2016. However, the key point is that by flooding the market with so much liquidity, could China avoid such complete collapse and basically, print itself out of a crisis? It does seem like such is taking shape. Or at the very least, China is already creating or has created a stimulus package to weather another potential liquidity problems.
Further, with Basel III bound to take effect in the not too distant future, FX value is bound to rise and with China’s currency to remain relatively stagnant, People’s Bank of China (PBC) must issue more RMB to balance its FX. But let’s consider an opposite argument. Though China participates in monetary sterilization and given its massive US reserves, it is absolutely irrational for China to impose robust sterilizations. With the lack of robust sterilization, it would lead to inflation and economic overheating and therefore, the government would have every incentive to reduce money circulation, which would be at the expense of the current argument of preemptive action against a liquidity crisis. With probably a lackluster sterilization effort, inflation would be an immediate concern. The concern is only exacerbated when you consider that China is printing cash to flood its market with liquidity. Do recall that inflation is another concern second to the possible housing crisis and inflation is a direct result of China’s possible method to deal with a possible housing crisis. So at this point, it might be safe to presume that China’s method of dealing with a possible housing crisis comes at the expense of an inflation bubble. If China intends to print its way out of problems, it has to suffer with inflation, which I don’t believe printing will solve the issue.
Now, China’s banking sector is extremely unhealthy with its big 4 banks, ICBC, Bank of China, China Construction bank, and Agricultural Bank of China boasting 46% of non-performing loans. At a staggering 46%, there seems to be a lot of debt forgiveness. That combined with the Chinese’s traditionally high savings rate essentially represents a transfer of wealth from the private to the banking sector, resembling a large hidden tax on household income. In fact, that high savings rate lowered consumption, which the 12th 5 Year Plan ironically intended to raise, and this collectively produces an unsustainable growth model with decreasing consumption. Now, the Chinese government has every incentive to encourage a high saving rate, despite the popular belief of a need to raise consumption. The Chinese government’s power rests in its control of money and therefore, increasing consumption would actually divest their power and stronghold over the Chinese people. And even if this first argument does not attract your attention, low consumption might serve as a partial offset to the inflationary pressures. Furthermore, China has been rumored to impose a price ceiling on food prices, that would certainly alleviate some inflationary pressures, though a price ceiling has historically suffered tremendous downfalls. Now even if there is an offset to the inflationary pressures and assuming that it is less of a concern at this point, that low lending rate and debt forgiveness are still serious areas of concern. To summarize, this is basically BAD DEBT and as we had grown too familiar with that concept by now, it is one of the critical triggers of the financial crisis.
Further, China’s GINI coefficient, representing the inequality between rich and poor, in which the higher the coefficient, the more sever the inequality, is sitting at a staggering 0.47 and for comparative purposes, US and France’s GINI coefficients are in the range of 0.31 – 0.35. Do note that 0.4 is the threshold for sever inequality. With that said, it is prudent to discuss the inequality model as another prong to the financial crisis. The inequality model centers around high default risk and consumption, but as already stated, consumption is low in China and therefore, this model might necessarily lend as much credence as the above analysis, though it still merits consideration as at least on paper, China is targeting higher consumption and such model is certainly a method to do so. Under this model, the wealthiest 5% of the population lends to the bottom 95% so that the 95% could maintain levels of consumption relatively close to the top 5%. If the bottom 95% are consuming beyond their means, it greatly increases the probability of a financial crisis. The 46% non-performing loans is a pretty good indication of high default risk. Here is the real problem presented by this model, the top 5% would continue to consume and invest in financial instruments or investments other than real product investments where the money invested would recycle to the bottom 95% to feed their consumptions. In actuality, the bottom 95% is leveraging to maintain its consumption and therefore, without going any further, a greater risk of default and that risk could spillover and devastate the system as we had formerly witnessed. Now, there are two solutions to this concern while still maintaining adequate levels of consumption, in which China is conducting one of the two. The first solution is to reduce debt and lower savings rate but this is not sufficiently robust to absolve wide spread default risk as its effects would be far too minimal. Even so, China does not adopt this solution as lowering savings rate is not in the party’s best interest. The second solution, as adopted by China is to increase the bottom 95%’s income. By doing so, the bottom 95% could reduce its reliance on leverage and attain greater power to demand foreign goods. But the problem is with increasing income, inflation would once again be a concern. So is the solution to consume less? Not likely, given the current bullish real estate market that is in fact growing irrationally.
But what really drives fear is the fact that China’s possible solution to a potential housing crisis fuels an inflation bubble, which if the bubble bursts, consequences could be rather severe. Inflation might be offset by low or lowered consumption and forget about the 12th Five Year Plan for a second, for concerns of power, the Chinese government might be interested in keeping consumption low as above mentioned. But if China keeps printing cash while keeping its currency artificially low and keeps fighting inflation with low consumption, it would eventually spur the wrath of foreign nations. If China decides to let its currency rise faster or even free its currency, which I believe at this stage is quite implausible, we might witness a complete currency collapse due to high inflationary pressure and if that is even a concern, too much liquidity or unhealthy liquidity. A housing crisis might be averted but this comes at the expense of heavy inflationary pressure which would drive China back for years or even a decade. But the concern is if China does not flood itself with liquidity and a housing crisis emerges, with Chinese psychology of fear, censorship, and their known aggressiveness, bank runs might be much more severe than the ABCP run witnessed prior to Bear Sterns’ collapse. In fact, the bank runs might even turn bloody. I dare not say it, but the panic might overspill and blossom into a four letter word starting with a “R” and ending with a “T.”
1. Cash printing could avert a potential housing crisis, but would grow the inflation bubble.
2. Non-performing loans drive down consumption, alleviating some inflationary concerns.
3. Inequality model drives consumption, leading to inflation, thus offsetting the alleviation done by non-performing loans, which isn’t a healthy economic form anyways.
4. Inflation bubble, if the above is correct, could trigger a currency collapse and major domestic disorders.
My economic analysis might be flawed. I would appreciate any form of input.