Seven Notes on the China Wildcard

1) Is China really growing or not? Wait, is that a stupid question, or what? Of course China is growing, and pulling the global economy out of the ditch as well. Read this report from Time. Uh, maybe not. What if it is all a lending bubble?

• Michael Pettis seems to think so, and I rely on his insights: RMB 1.5 trillion in new Chinese lending — can we turn this thing off?
  and, I wasn’t impressed by China’s high reserve and GDP growth numbers.
• Also this article from Bloomberg.
• And this comment from Andy Xie of Morgan Stanley. This makes me less bullish on energy and commodities.

What seems to be happening is that the powers that be in China are encouraging banks to lend aggressively. Firms in China aren’t finding a lot of opportunities in export markets, so they build up inventories “that they know they will need eventually.” Financial counterparties and individuals speculate on financial assets like real estate and stocks as they find cheap financing available. (Example)

That’s my view of China at present. I think those that are arguing for a resurgence in China at present are missing the similarities to the late 1980s with Japan where large amounts of productive capacity were built up with no markets large enough to sell the incremental production to.

I could be wrong, but this is leading me to lighten up on cyclicals. Maybe some utilities…

2) With all of the noise of those looking for a replacement for the US Dollar as the world’s global reserve currency, I have two questions:

• Are the surplus nations looking to reduce their surpluses, and thus suck in fewer foreign assets?
• Is there a new deficit nation that is politically stable, militarily strong, etc., that is capable of running current account deficits for some time? Surplus nations need a safe place to invest.

3) In the meantime, the US tries to assure trading partners that their purchasing power is safe. We remember the laughable assertion of Tim Geithner trying to assure the Chinese that they did not have to worry about devaluation of the dollar. Well, now he is saying the same things to the Saudis. At least with the Saudis, we are doing their bidding in the Middle East, by bottling up Iran, so perhaps he does not have to worry so much there.

4) Back to point 2. Are the current account surplus nations willing to consume from the rest of the world and flip around to deficit conditions, letting their currencies appreciate, and killing their politically powerful export industries? That’s what it will take to replace the US Dollar. I don’t care who is arguing against the US as a reserve currency. The reserve currency must by nature offer high quality securities on net to the surplus nations to invest in. It must run current account deficits on average.

That’s why China can’t be the world’s reserve currency. China isn’t willing to stop export promotion, or encourage domestic consumption. India and Russia may kvetch as much as they like, but both are in the same boat as China, but to a lesser degree.

Oddly, the best policy for most of the complainers would be to allow/encourage imports, and stop export promotion. Freed from these distortions, the global economy would start to normalize. Cross-border capital flows would decline because exports would not need to be balanced out.

5) The US has no interest in selling Yuan-denominated debt yet. China eagerly buys Treasuries today.

6) Does the one child policy fuel excess savings in China? Maybe, but I doubt it is a big factor. Dowries are unlikely to eclipse the actions of the central bank and government.

7) A final note from Andy Xie — there is a lot of momentum in China, but little underlying change in the fundamentals.

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My summary is this: To the degree that the recent upturn is driven by expectations that China pull the global economy out of the ditch, the move is mistaken. As my friend Cody Willard asked me three years ago, what happens if Chinese growth proves to be a sham? Can you trust their statistics?

My answer was that I wasn’t certain, but that things would get more clear if that were the case — and I think things are clearer now. My policy implication is to move assets out of export-driven sectors, and those driven by China demand. Utilities, here I come.

Comments

[Clive Corcoran]

I would just make two comments to your stimulating ideas.

1. China's bubble could have a lot further to build before it all comes tumbling down - just look at the bubble that took seven years to build in the US from 2000-2007

2. Re new global reserve currency - you ask- "Is there a new deficit nation that is politically stable, militarily strong, etc., that is capable of running current account deficits for some time?"

My question back to you would be - why does the global currency have to "belong" to a nation state - why not envisage a supra-national currency beyond the printing presses of any one government?

2009 Jul 17 11:19 AM

[Michael Clark]

Very interesting article. Thank you for posting.

2009 Jul 17 03:01 PM

[Ricard]

My understanding of China's advocacy of a new reserve currency had nothing to do with the RMB, but some sort of currency based on a UN-style international consortium. I don't think China has ever advocated that the RMB replace the dollar as a world reserve currency precisely because they are cognizant of the arguments you've presented.

2009 Jul 17 03:28 PM

[Ricard]

Here's an article to corroborate:

www.bloomberg.com/apps...

key quote:

“To avoid the inherent deficiencies of using sovereign currencies for reserves, there’s a need to create an international reserve currency that’s delinked from sovereign nations,” the People’s Bank of China said in its 2008 review released today. The IMF should expand the functions of its unit of account, Special Drawing Rights, the report said.

2009 Jul 17 03:32 PM

[Sober Realist]

I tried to pin a date on this bursting bubble and here's what I got:

Michael Pettis:
" I expected that after the 1987 crash Japan’s economy would get into serious trouble, but it enjoyed another 2 years and more of bubble conditions and high growth before the final adjustment took place. I think the same may happen in China. And as one of my Columbia professors assured me before I became a trader, “never short a bubble.”

Derek Scissors, Ph.D.:
from his recent (7-17-2009) paper "China Refuses to Adjust Its Economy"
"China's economic policies have shifted from being unsustainable over the very long term to being unsustainable for any more than one year. The core of this degeneration is the role of investment, but behind that investment, and making it possible, is bank lending..."
www.heritage.org/Resea...

And this article just out:
JULY 17, 2009, 7:34 A.M. ET Riding China's Stock Market Bubble

"...Individual investors too are piling in. In the mainland, more than 1.6 million stock trading accounts were opened in June – 68% more than the year before.

This buying could go on for some time. If easy money is the main driver of stock market gains, then predicting Beijing's efforts to turn off the taps is key to knowing when it'll all end.

For now, economists expect little in the way of tightening – with consumer prices in China still falling, and the economy far from secure in its recovery – until next year some time..."
online.wsj.com/article...

If loaning out more money is the only way to keep "growth" of any kind going, then it will continue for as long as possible (Summer 2010) until the CCP have some inkling that the rest of the globe is stabalizing. Unfortunately, their stimulus measures will run dry before Western consumption returns to save China's export-driven economy. China has no developed internal market to replace their old customers and is light years away from developing one. The Chinese have no plan B for an L-shaped recovery which is what we are facing. So I see next year as a very tumultuous period.

2009 Jul 17 05:05 PM

[Mad Hedge Fund Trader]

The Chinese certainly think they're growing. China’s National Bureau of Statistics announced the data for the only country that matters right now, showing that Q2 GDP growth came in at 7.9%, much better than expected. The Middle Kingdom’s gold and foreign currency reserves soared to a new record of $2.13 trillion. The main impetus has been the country’s $586 billion stimulus program announced earlier this year, which unlike our own, seems to be delivering immediate and impressive results. New bank lending in China is through the roof, thanks to aggressive government prodding. The China ETF (FXI) had a great week, and is now up 74% from my New Year recommendation Potentially of far greater importance is China’s decision this week to liberalize foreign capital outflows, a development that went virtually unreported in the Western press. This will make billion of dollars available for direct investment in foreign advanced technology and crucial natural resources. It also means that less cash will be available for investment in US Treasuries, an asset class the Chinese are clearly tiring of. For an in depth discussion of this important reform please read Keith Fitz-Gerald’s excellent piece at www.moneymorning.com/2.../ .

2009 Jul 17 05:15 PM

[Thomas J. Gordon]

I have a question about China. Is a stimulus funded by real saving different than a stimulus funded by increased borrowing or money printing? The chinese gov't famously had 2 trillion in accumulated balance of payment reserves. If the Chinese spent their reserves on stimulus, they really had the money saved up from before. Does that make their stimulus work better than the u.s. stimulus, which had no real taxes or saved prior taxes to support it?

2009 Jul 17 06:34 PM

[Boxed Merlot]

One difference in their stimulus funds is that we will continue to pay interest on their stimulus funds because they're based on interest bearing notes we sold them. So they will get returns from us in addition to any they receive from their domestic borrowers. That's the good thing of being a lender and not a borrower.


On Jul 17 06:34 PM Thomas J. Gordon wrote:

> I have a question about China. Is a stimulus funded by real saving
> different than a stimulus funded by increased borrowing or money
> printing? The chinese gov't famously had 2 trillion in accumulated
> balance of payment reserves. If the Chinese spent their reserves
> on stimulus, they really had the money saved up from before. Does
> that make their stimulus work better than the u.s. stimulus, which
> had no real taxes or saved prior taxes to support it?

2009 Jul 17 08:00 PM

[nmelendez]

China has more reserves than all US Banks, including GS, put together. They are going to act as a bank with the countries it has reached exchange agreements (Think Brazil, Argentina and various others). They are doing the same in Iran and Africa.
Think of it like this, US wants China to let the Yuan float and China says they will,,,,after the US relinquishes it's world reserve currency for the dollar. Which comes first, the chicken or the egg?

2009 Jul 18 01:45 AM

[fran]

as long as the world advocates fiat currencies, the reseve will reside with the nation most likely to survive "world" crises. today, that is the US of A. in the far future, WHO KNOWS the answer.

regards alternatives[IMF etc], would you invest in it, whatever it really is. would you keep your IRA, 401K, CHILDRENS COLLEGE FUND in IMF securities? how about UN[united nations] bonds, notes, currency[called UNicorns]. the record of EU and the EURO has been an exemplary model to follow?
for what laudatory, responsible, trustworthy "fiat" enterprise would you be in a state of euphoria to back your paper wealth?

GET SERIOUS FOLKS! at the rate we're managing our finances and economy, we'll have an answer in the future. but don't rush things.

2009 Jul 18 09:09 AM

[Strangewalk]

While this post may seem off topic, the point is that investing in China now is like playing craps in Las Vegas, and you'd probably have better chances there.

How did China accumulate such massive foreign reserves? Is it because the government imposed the world's highest corporate tax rates on its export manufacturers while pursuing aggressive, unfair, deceptive mercantilist policies in foreign trade along with massive copyright/patent infringement and piracy? Factories were limited in ability to pass profits on to workers as higher wages, which preempted the development of a domestic, consumer driven economy, while ensuring continued CCP control of the purse strings. China lost its golden opportunity, the death of globalization has begun with a bang and Smoot-Hawley will certainly be repeated in some form. Now all the Chinese government can do is play monetizing, speculation and bubble games while buying time from the certain inevitability of disaster that it actively participated with the Americans in making. Also, I don't think the Chinese have nearly the same ability to sustain their bubbles as the Americans did, especially in the current global atmosphere of extreme volatility and fear.

2009 Jul 18 09:57 PM