Asia: The Next Big Bubble

In a recent post called Pegged renminbi will be hard to internationalize, we discussed the issue China faces as it tries to maintain its export based economy. It does so by holding the currency artificially low to make their product look cheaper to the world. To accomplish this, they must continuously purchase dollars, while selling renminbi. But where do they get the renminbi to sell?

Well in what's called an "unsterilized" FX transaction, China simply "prints" the new renminbi to sell (as opposed to a "sterilized" transaction where the central bank sells currency spot but agrees to buy it forward, thus not impacting the money supply.) The newly "minted" renminbi sold by the central bank for dollars simply gets deposited in it's banking system, increasing the money supply. This is how they keep the currency from shooting up 30%. It's a dangerous game, because all that new renminbi deposited in China's banks has to go somewhere.

With the money supply growing rapidly, China could raise interest rates to control inflation. But if they do so while the USD rates are nearly zero, it will put even more upward pressure on their currency. If you have an asset at par with the dollar that pays higher rates and can only go up in value, you'd be buying as much as you can. So as long as Western rates remain low, China has to keep their interest rates relatively low.

Banks in China are lending and will continue to lend at least some of those excess deposits. Thus unlike in the US, where banks are in the process of repairing their balance sheets, China has what's called a multiplier effect going.

According to recent research from HSBC, this phenomena of artificially low currency values and local banks that are able to lend is prevalent across the exporter nations of Asia. This stimulus will create a tremendous asset bubble across the region (particularly in equity prices and real estate).

If people fear that all the stimulus in the US will create inflation, think about countries with a real multiplier effect. Given that the US and Europe will keep their rates low for a while, by the time the stimulus in Asia is taken away the bubble momentum will be unstoppable.

From HSBC: Asian policy rates have to stay low as long as Western rates stay low




From HSBC:

The remarkable thing about such liquidity-driven asset bubbles is their long-cycles, underlining the eventual potency of loose monetary policy. Also, successive monetary tightening over the course of the bubble has apparently little impact: once the financial accelerator goes into full throttle, it takes aggressive tightening to pop the bubble – and, more often than not, policy-makers are reluctant to step up for fear of bringing down the house.

Credit continues to grow in Asia with no major slowdown due to the crisis.

From HSBC: Credit growth across Asia


At the same time deposit rates are growing as well, driven in part by the "unsterelized" currency interventions that force dollar sellers to deposit the currency proceeds in that country's banks.

Deposit growth y-o-y


Deposit growth and credit expansion accelerate the monetary base growth.

Base money growth y-o-y:


All this translates into loose monetary conditions in Asia that lead to an asset bubble:

The Monetary Conditions Index; y-o-y



Expect corporate leverage, property, and equity price levels to balloon to dangerous levels as liquidity continues to grow unabated throughout Asia. This is the next big bubble.

Comments

[EUARTE:]

The effect of a China bubble burst is enormous. Brasil, for instance, has become to rely on China as a buyer of their resources. The United States and the EU are not buying much now and won't for a while. Even then they can not match the huge purchases by China. This could cause a dangerous crisis for the Real. The Real is over valued because of these Chinese purchases and the carry trade. The Real will lose it's value by a great margin.

Aug 09 09:40 AM

[Dave Wrixon:]

"It does so by holding the currency artificially low to make their product look cheaper to the world. To accomplish this, they must continuously purchase dollars, while selling renminbi. But where do they get the renminbi to sell?"

If anyone else here understands a word of this I would be grateful for an explanation.

Naively, I thought the Chinese got their dollars by supply goods, and the US paid for them by printing money out of fresh air. Sure, there is a massive danger in this, but the mistake appears to be crediting the dollar with any value in the first place. I think the Chinese are becoming increasingly aware of this error.

Aug 09 11:36 AM

[williamwu:]

Sure it could be a great big bubble. But what if the stock market rises another 10000 points from here on because of this "bubble", and drops another 9000 points due to the bursting of this "bubble" in the next bottom. I would still be better off by 1000 points!

Aug 09 12:54 PM

[Tony Daltorio:]

These articles talking about the China bubble and ignoring the biggest bubble - the US - always amaze me as to their lack of knowledge.

The author should pick up a recent issue of the Financial Times and read about how within a few years, the Chinese will be doing trillions of dollars in business in the renminbi and begin to internationalize their currency.

And despite the authors's claims, US banks have NOT repaired their balance sheets - the dirt has merely been swept under the rug.

Aug 09 02:10 PM

[Ricard:]

Good article. I think the author's point is that a bubble may emerge, not that it is already set to pop. I fully agree with this thesis. It's quite possible that this next bubble may dwarf the one that just preceded it.

Aug 09 03:02 PM

[Jeff Nielson:]

You don't have a clue what you are talking about. There is REAL growth in the Chinese economy, REAL wealth being created with its huge manufacturing base, and a MASSIVE pool of SAVINGS to deploy to further this growth.

Every one of these factors is the EXACT opposite of the U.S. bubble-economy - where the ENTIRE "house of cards" is built on huge amounts of excessively-leveraged. This is not just a "bubble economy", it is a "Ponzi-scheme economy" - in the truest sense, where it can only SURVIVE month-to-month by printing money just to pay the INTEREST on its debts.

Aug 09 03:43 PM

[Mad Hedge F...:]

No kidding. When the stock market rolls over, don’t expect to be able to hide anywhere, except in cash. If someone mentions the word “decoupling”, turn around and walk away, delete their number from your Blackberry, delink from their Facebook page, and block their Tweets. Knowing this individual will be seriously injurious to your wealth. To see how highly correlated markets are these days, take a look at the chart below from StockCharts.com. It shows high correlation between stocks (SPX) , gold (GLD), and oil (USO), and similarly high inverse correlations with bonds (TBT) and the dollar (UUP). I have always viewed diversification as a great way to lose more money in varied places with more exotic sounding names. When the Dow drops, the Shanghai market ($SSEC) will probably fall twice as fast, as it did last year.

Aug 09 05:44 PM

[StankyPigano:]

Ditto to Jeff Nielson's response.

Here's a little perspective: the U.S. consumes about 25 barrels of oil per capita annually. Japanese and European annual oil consumption per capta is in the mid teens. China's oil consumption in 2007 was just over 2 barrels per capita!

With real savings and real wealth creation, there is also considerable headroom for demand growth before it can even remotely be considered a bubble. It is a mistake which defies all Chinese history to assume they will continue to rely on exports as Japan has.

As an aside, I think the reason China is stockpiling copper and other resources is because they see the recent political changes in India. If India decides to build 50,000 miles of roads over the next 5 years like China just did, there won't be enough of ANYTHING in the commodities pits to meet the incremental demand...

Aug 09 05:52 PM

[ArtfulDodger:]

Well certainly if the Asian nations keep pumping fiat money into their economy no end, there will be a bubble.

But they have a lot of people to take up the slack of all that money, so it could take a long time to come to a pulsating head and then burst.

Our ability to recognize the infected head is key, and clearly that is not now.

Aug 09 11:14 PM

[ArtfulDodger:]

Well certainly if the Asian nations keep pumping fiat money into their economy no end, there will be a bubble.

But they have a lot of people to take up the slack of all that money, so it could take a long time to come to a pulsating head and then burst.

Our ability to recognize the infected head is key, and clearly that is not now.

Aug 09 11:14 PM

[jockum:]

time for a new currency. a global currency based on hydrogen energy. when the Chinese and the Indians start to use those 50 000 miles of road, and airconditioning, well,,,, we probably do not worry over bubbles, unless it is in the water, which will be everywhere.

Aug 10 03:08 AM

[Cliff Wachtel:]

great article and comments. Can anyone tell me of a good (5%+) income play on commodities or china? Haven't found too many commodity based stocks that pay high dividends outside of the energy, especially Canadian income trusts, and very few Chinese companies pay anything. TNH is the only fertilzer play I know of , and there are a few iron ore income plays. Interested to hear any ideas. You can email me at [e-mail] thanks in advance, Cliff

Aug 10 09:33 AM

[Jeff Nielson:]

Yet another commentator who doesn't have a clue what an "asset bubble" is. China and other Asian economies are rapidly building wealth through manufacturing - like the U.S. USED TO do in the 20th century.

Did you hear anyone calling the U.S. economy a "bubble" in the 1950's?

Asian governments have large operating surpluses and Asian citizens have HUGE savings. There growth is fueled by REAL wealth - not trillions upon trillions of leveraged-debt, which is what the U.S.'s bubble-economy is based upon.

Aug 10 10:44 PM

[Dr. O:]

Happy to ride a bubble on the way up. Now, will the markets provide us an entry point with a sharp pull back in the Asian markets?

Aug 10 11:37 PM

[Michael Clark:]

Who is going to buy their manufactured goods when America and Europe stop buying? Exports are down another 21% in July. Imports in China also down. I think the Chinese would rather buy stocks and land that the cheap (shoddy) products the Chinese are producing.

If you compare China now and America in the 1950's, you also have to compare the laws protecting business, private property, etc. It's pretty hard to compare America and China in terms of social environment and laws. Also, America in the 1950's was looking at a freshly destroyed world to help rebuild. Consumer debts were relatively low. Today, we've all just had a huge feast and we won't be ready to eat again for some time.

China can sell their cheap products locally. But that won't make them the engine of the world-recovery.


On Aug 10 10:44 PM Jeff Nielson wrote:

> Yet another commentator who doesn't have a clue what an "asset bubble"
> is. China and other Asian economies are rapidly building wealth through
> manufacturing - like the U.S. USED TO do in the 20th century.
>
> Did you hear anyone calling the U.S. economy a "bubble" in the 1950's?
>
>
> Asian governments have large operating surpluses and Asian citizens
> have HUGE savings. There growth is fueled by REAL wealth - not trillions
> upon trillions of leveraged-debt, which is what the U.S.'s bubble-economy
> is based upon.

Aug 11 01:25 AM

[Belome:]

Yet another commentator who doesn't have a clue what an "asset bubble" is. China and other Asian economies are rapidly building wealth through manufacturing

China is a bubble plain and simple.. btw not everyone that disagrees with you is an idiot, China's economy is built on manufacturing, great insight...not... we have known that for 20 years. These goods were sold to a U.S. consumer leveraged to the hilt and is now dead and will be for a number of years so go ahead China and restock... build away... good luck selling your shit in the U.S.

Aug 11 01:59 AM

[Paul Harper:]

"Who is going to buy their manufactured goods when America and Europe stop buying ? "

have a look at where China is entering into currency swap agreements & you have your answer : Brazil, Taiwan, Argentina, Russia, Indonesia, Thailand.
also, please don't discount Africa, the Chinese have just set aside $2 Bn to invest in infrastructure projects in the continenet (mostly related to commodity deposits) ... they are not doing this out of social philanthropy, they are slowly but surely creating new markets for their "cheap & shoddy" goods.

Aug 11 03:16 AM

[HardwoodFlo...:]

I’m sorry if this is just anecdotal or colloquial but it might help give some perspective on China…

When China started coming at the US hard in flooring products in the early 2000 thru 2004 they were buying in US lumber and selling it back to the US below raw material cost. I know it’s amazing. How is that possible, well it wasn’t. The Companies were receiving a stipend per SQ Meter sent to the US (sort of bonus export incentive) well it just wasn’t sustainable.

Another great example of Chinese efforts is marketing. Bamboo is probably the least “green” product in the market place. Yet the Chinese have done a great job convincing people that it is. There are so many environmental issues with bamboo that this would take paragraphs to help people understand. One of the most important elements however is that the lignin breaks down over time making it basically a disposable product.

We all heard over the last 10 yrs (since Clinton gave them MFN status), in fact it was argued by flooring industry insiders, that the demand in China of the burgeoning middle class would be so large that eventually China would become net importers of flooring not exporters. Well this hasn’t happened. Chinese flooring companies are floundering, even with this latest stimulus, they are not sustainable. Weather its bamboo stolen from some panda’s forest or import raw materials they cannot compete without a subsidy. And not even then apparently.

The point is this: the burgeoning middle class of china using enough products to help transition china from an export economy to one that will generate enough internal demand to make it on it’s own just hasn’t happened- sorry that’s fact. Secondly, they can put out all kinds of BS marketing stories about their country and some people will believe them. The fact is they have to keep buying us dollars to keep the US strong so that the dollar just doesn’t collapse because their products will become more expensive relative to the dollar (the Yuan is already 30% undervalued by most estimations and the reason to keep it depressed is to what help an import economy?)

This is just anecdotal stuff. People will probably think I’m an idiot but it is the truth. I love the idea that people who don’t believe the China story are ignorant. i guess that people who believe everything a chinese governement tells them could be naive?

Aug 11 02:11 PM

[Walter Kurtz:]

Thanks everyone for their comments. Very interesting stuff. I just want to reiterate that this article is based on a recent research report from HSBC called "Blowing Bubbles". For those who are interested in a copy of the full report from HSBC, I have it embedded at the bottom of the post on Sober Look - here is the link.
narrowtranche.blogspot...

Aug 11 08:30 PM

[Paul Harper:]

A liitle bit more on China & new markets, I have posted an instablog of an article from The Australian regards the China Development Banks new Africa fund : seekingalpha.com/insta....

Walter, thanks for the link, look forward to reading that a little later today.

Aug 12 04:43 AM