More Bubble Talk from the Financial Times

Here's some more food for thought from the Financial Times for the many bubble-deniers in the world, such as Jim Rogers as seen in this item previously. The British business daily seems to be full of "bubble stories" in recent weeks, just a few days ago publishing Nouriel Roubini's Mother of all carry trades faces an inevitable bust.

China rushes towards a Japan-style bubble
By Peter Tasker

Emerging markets, it seems, have had a good crisis. In contrast to the debt-ridden G7 economies, they have quickly resumed their growth trajectory. No surprise, then, that US emerging market mutual funds are experiencing record inflows. The stellar performance of the Brics markets - Brazil, Russia, Indian and China - is due to continue into the distant future.

Such is the narrative now forming among investors. To anyone who has lived through the rise and fall of the Japanese bubble economy, it should set off alarm bells.

Remember that it was in the years following the 1987 "Black Monday" crash that Japanese assets went from being expensive to absurdly overvalued and the Nikkei's dizzy rise to 39,000 forced the bears to throw in the towel.

Then, as now, the logic seemed unassailable. While the western world was stuck in the post-crash doldrums, the Japanese economy had got back on track with apparent ease. Japanese corporations were using their high market capitalisations to finance acquisitions of foreign trophy assets. Japanese banks boasted the world's strongest credit ratings.

But what you saw was decidedly not what you got.

Just the fact that government sponsored bank lending in China this year has grown to staggering proportions should set off alarm bells for most people, but, human nature being what it is, many look past that development all too easily.

The Wall Street Journal joined in with their own bubble warning of sorts with the lead story in the Money & Investing section yesterday- Fears of a New Bubble As Cash Pours In.

Pretty straightforward stuff - zero percent interest rates, a large and growing carry trade, government profligacy in the name of economic recovery.

Back to the Financial Times and the parallels between 1980s Japan and 2000s China...

The crisis, far from leaving Japan unscathed, exacerbated its structural problems and laid the groundwork for a far greater disaster. And it was the weak western economies, not Japan, that produced healthy investment returns over the next decade.

In reality, 1980s Japan was never going to be terminally damaged by weakness in export markets. Its current account surplus and strong fiscal position provided the macro policy leeway to make any slowdown strictly temporary. The Bank of Japan duly put the pedal to the metal and the recently deregulated banks went on a patriotic lending spree. High-end consumption boomed but the real action was in the asset markets and capital investment, which soared as a proportion of gross domestic product.

Sound familiar? It should, because the same dynamic is evident today in China and some other emerging economies.

Interest rates have been far too low for far too long. If the natural interest rate is, as the Swedish economist Knut Wicksell posited, around the level of nominal GDP growth, then China's interest rates should have been close to 10 per cent for most of this decade. Alan Greenspan, former chief of the US Federal Reserve, has been criticised for holding interest rates too low and setting off a housing and credit bubble in the US. But if US monetary policy was wrong for the US, it was even more wrong for the high-growth countries that "imported" it. The result could only be a massive misallocation of capital.

At the 2008 peak, the price-to-book ratio of the Shanghai stock exchange was over seven times, well above the five times achieved by Japanese stocks in 1989. After the turbulence of the past 18 months, the ratio has fallen to 3.3 times, still the world's second highest after India, and residential real estate trades at multiples of income that make the US housing boom look tame. Bulls justify such lofty valuations by plugging high growth numbers into their models. Historically, however, the linkage between high GDP growth and investment returns is tenuous. The years of the Japanese economic miracle saw poor stock market performance, and the market indices of high-growth economies such as Korea, Taiwan, and Thailand have made little progress for 20 years in dollar terms.

What is scary is that the current frothiness of emerging markets, centred on China, may be only a taste of what is to come.

For most of the 1980s, Japan, like China today, used government direction of bank credit ("window guidance") to overlay monetary policy. It was the combination of banking deregulation and the G7-sanctioned surge in the yen that ushered in the final manic stage of the Japanese bubble.

At its peak, the grounds of the Imperial Palace in Tokyo had a greater theoretical value than the entire state of California. By then there was no way out - asset market collapse and financial system wipe-out were baked in the cake.

If China continues to follow the Japanese template, the end of the dollar peg will be the trigger event, setting off a Godzilla-sized credit binge. Why would China's rulers embark on a such a disastrous course? Because the alternative - unleashing deflationary forces stored up over years of mercantilist policies - would be too painful to contemplate. That was the choice made by Japanese policymakers, who had 100 years' experience of managing a quasi-capitalist economy.

This time the denouement would be one of the biggest bubbles in history, probably in scale and certainly in number of people involved. Could China weather the subsequent financial turmoil as stoically as Japan? It seems unlikely; at the least its ascent to global hegemony would suffer an interruption.

If China does end the dollar peg, then it will be, "Katie bar the door" - we'll see things that will make even the 1980s Japan bubble look tame.

It's hard to imagine that the Chinese government will allow that to happen, but, currency crises (something that we may be barreling toward at the moment) have a way of forcing leaders to do things they might not otherwise do.

Comments

[socrateaz:]

I know Most might think I am crazy. I think a fast expanding stock market is a sign people within that country do not know what to do with the monies they have. The market becomes the choice that appears least bad. When there are lots of choices as to where to put monies, then stocks will move upwards slowly., real estate will move up slowly, and so will commodities! Any time period where prices change markedly is a sign of imbalance in the economy. A lack of choices will cause what appears to be the best choices to balloon, and the worst choices to tank. Most Investors spend their lives looking for expanding balloons to latch onto. And try to get out of deflating balloons. The successful usually get in after a deflating and get out before the next deflating in value. That is where charting works. And where investor sentiment gives clues. Bbottom fishers tend to understand the psychology of fear where when the fear becomes great enough, then a good investment is ahead. Momentum investors understand the psychology of enthusiasm where when people become more excited, they want to get in on it too! Those who get excited last are often the slowest to get excited and usually look to get in at a better price. They are the suckers for when they see those supposedly better prices, the upward action often has already taken place. Often the better price is actually the reduction in excitement which indicates the top has already been reached. I think we are currently in the period where many have been waiting to get in before the prices continue higher. But I think they are in for continued weakness for awhile. because the momentum is falling off. Momentum downward appears to be accelerating. The near future will be interesting. My guess is lower prices short term. If downward momentum does not pick up soon a good buy will present itself later this month for the bottom fishers. And the momentum people will see a good December to invest.

Nov 05 05:36 AM

[nexusil:]

If the linkage between high GDP growth and investment returns is tenuous, why is the "natural" interest rate around the level of nominal GDP growth?

If the peg breaking will trigger the formation of the biggest bubble in history, why should investors exit before this event occurs?

You are not making any sense.

Nov 05 05:40 AM

[coreopsis:]

This article is perfect evidence of all the fallacious 'thinking' in the world that Nassim Taleb has highlighted so eloquently.

While I do understand that to most Westerners the Chinese and Japanese look alike, one would hope that people with minimal education levels could recognize:

Japan is not China, nor vice versa.

The Japanese and Chinese governments are not the same, in theory or practice.

The historic phases of Japan in its 'bubble' and China today are not remotely similar.

A really sad thing to have to point this out.

Nov 05 11:24 AM

[Alan Young:]

As Jim Rogers says, how can you call it a bubble when it's only half of its previous high? If a new bubble is forming, it has a long way to grow. I'd rather be growing with it than standing outside carping about it.

Nov 05 11:30 AM

[debtacid:]

Just sit back and look at the pretty bubbles. Bubbles are good, bubbles are your friend. Follow the shiny new bubbles. Bubbles will make you rich. Pay no attention to that man behind the curtain...

Nov 05 02:17 PM

[doubleguns:]

When a book comes out about the "China that can say No", its time to get worried.

Nov 09 07:47 PM

[Mark Bern:]

There are many differences between Japan then and China now. There were many differences between Japan then and the US just two years ago. However, there were some similarities in the later case and we shall see, in the end, if the similarities or the differences win out over time. In the case of Japan vs China, the same will be true. But I often think that those in government who believe they can manage an economy at the level of perfection necessary to avoid all crises are either egomaniacs or stupid, or both. Market forces will eventually take over and reality will overcome even the best laid plans.

I do find the comparison interesting, though I doubt that the big fall (if it comes in China) will happen in the next year. China (and the rest of the BRIC countries) has become a major focal point for investing both fpr internal funds generated from export surpluses and domestic earnings and for external funding from foreigners. Those engines will probably sustain the continued rise for a while yet.

Nov 10 03:03 PM

[tripleblack:]

I would agree with that. Even seeing the case precisely as equal, it took years for the bubble to encapsulate Japan.


On Nov 10 03:03 PM Mark Bern wrote:

> There are many differences between Japan then and China now. There
> were many differences between Japan then and the US just two years
> ago. However, there were some similarities in the later case and
> we shall see, in the end, if the similarities or the differences
> win out over time. In the case of Japan vs China, the same will be
> true. But I often think that those in government who believe they
> can manage an economy at the level of perfection necessary to avoid
> all crises are either egomaniacs or stupid, or both. Market forces
> will eventually take over and reality will overcome even the best
> laid plans.
>
> I do find the comparison interesting, though I doubt that the big
> fall (if it comes in China) will happen in the next year. China (and
> the rest of the BRIC countries) has become a major focal point for
> investing both fpr internal funds generated from export surpluses
> and domestic earnings and for external funding from foreigners. Those
> engines will probably sustain the continued rise for a while yet.

Nov 10 03:25 PM

[Mark Bern:]

It all depends on how fast the bubble gets inflated, IMHO. Faster means it pops sooner. Slower means it takes longer. Slow enough, or even with a few intermediate corrections, and it could go on forever. So, I think the rate will depend a lot on external factors that could require China to push more in the domestic area for growth than they otherwise would. That could inflate things faster. In other words, the longer the developed economies take to recover, the faster the Chinese bubble will have to inflate to counterbalance and sate the internal need to keep creating jobs.

I could be wrong. But in any event, it should be interesting to watch (and hopefully profit from).

Nov 10 04:03 PM

[tripleblack:]

I absolutely agree, Mark. Its the way I see things as well.

The powers in Beijing are being forced to continue stimulus and the real estate bubble, further and faster than they might like because of the recession and its affect on their customers. They have no other choice, right now. Later, when they DO have a choice, I would expect them to throw on the brakes and shut down the subsidies fueling the inflating bubble.

Makes sense.


On Nov 10 04:03 PM Mark Bern wrote:

> It all depends on how fast the bubble gets inflated, IMHO. Faster
> means it pops sooner. Slower means it takes longer. Slow enough,
> or even with a few intermediate corrections, and it could go on forever.
> So, I think the rate will depend a lot on external factors that could
> require China to push more in the domestic area for growth than they
> otherwise would. That could inflate things faster. In other words,
> the longer the developed economies take to recover, the faster the
> Chinese bubble will have to inflate to counterbalance and sate the
> internal need to keep creating jobs.
>
> I could be wrong. But in any event, it should be interesting to watch
> (and hopefully profit from).

Nov 10 04:10 PM