What Are the Odds That China Will Follow 1920s U.S. and 1980s Japan?

by: Reggie Middleton

Today in the news - China Inflation, Production Accelerate, Adding Pressure for Stimulus Exit:

March 11 (Bloomberg) -- China’s inflation reached a 16-month high, industrial output climbed and new loans exceeded forecasts, adding to the case for the government to pare back stimulus measures.

Consumer prices rose 2.7 percent in February from a year earlier, the National Bureau of Statistics said in Beijing today, compared with the 2.5 percent median estimate of 29 economists surveyed by Bloomberg News. Seasonal factors stemming from a weeklong holiday may have boosted prices. Production rose 20.7 percent in the first two months of 2010, the most in more than five years.

Contrary to many, not only do I believe China is in the throes of a credit driven asset bubble, but its touted safeguards point the way to drastic correction.

China's huge foreign reserves: Not a savior for the country if the asset bubble bursts

The concerns highlighted by Michael Pettis (a professor at Peking University's Guanghua School of Management, "Never short a country with $2 trillion in reserves?") are telling, particularly that huge foreign exchange reserves are not a sure shot solution for preventing China from a future financial crisis. I would like to amplify the message contained therein, since the news coming out of China reinforces the fact that it is really not "different this time" so emphatically.

The author states:

...Let us leave aside that the PBoC's reported reserves are a lot more than $2 trillion, and that if correctly accounted they would be pretty close to $3 trillion. China's foreign reserves are certainly huge. They add up to an amount equal to about 5-6% of global gross domestic product.

But they are not unprecedented. Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.

The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as "all the bullion in the world". At the time, total reserves accumulated by the US were more than 5-6% of global GDP.

The second time occurred in the late 1980s, when it was Japan's turn to combine huge trade surpluses with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5-6% of global GDP. By the late 1980s, Japan's accumulation of reserves drew the sort of same breathless description - much of it incorrect, of course - that China's does today.

Needless to say, and in sharp rebuttal to Friedman, both previous cases turned out badly for long investors and brilliantly for anyone dumb enough to have gone short. During the early years of the Great Depression of the 1930s, US stock markets lost more than 80 per cent of their value, real estate prices collapsed, and the US economy contracted in real terms by an astonishing 30-40 per cent before recovering in the 1940s.

Japan's subsequent experience was economically less violent in the short term, but even costlier over the long term. During the period following its astonishing accumulation of central bank reserves, its stock market also lost more than 80 per cent of its value, real estate prices collapsed, and economic growth was virtually non-existent for two decades.

Reserves of course are not useless as an enhancer of financial stability, but their use is for very specific forms of instability. Having large amounts of reserves relative to external claims protects countries from external debt crises and from currency crises.

The key term here is "external". China does not face external debt concerns, as the country's foreign claim as per BIS (Bank for International Settlement) stood at only $278.6 billion at the end of September 2009 (which is only 5.3% of the country's 2010 expected GDP as per IMF). However, China's domestic debt currently remains at an uncomforting level (as we will see in our discussion below).

The risks that China faces today (and the US in the late 1920s and Japan in the late 1980s) is of excessive domestic liquidity having fueled asset and capacity bubbles, the latter requiring the uninterrupted ability of foreign countries to absorb via large and growing trade deficits. These risks include an explosion in domestic government debt directly and contingently through the banking system...

This risk is visible in the recent finance ministry announcement to nullify all guarantees by local governments for loans taken by their financing vehicles, and its plan to issue rules banning all future guarantees by local governments.

If local government debt that China's local governments have been raising through off-balance sheet (and similar) investment vehicles to circumvent direct borrowing regulations and which is not counted in official calculations, is included in the total debt - then the country's debt could rise to 39.838 trillion Yuan or $5.8 trillion. This puts China in similar debt standing with many of the PIIGS, being that it's accounting for 96% of GDP, much higher in comparison to the IMF's estimate of 22% which excludes local-government liabilities, in 2010, based upon research by Northwestern University's Professor Victor Shih, who estimates China's local- government outstanding debt at the end of 2009 at 11.429 trillion Yuan.

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This puts China 4th in line, behind Italy, Belgium and Greece in terms of gross debt to GDP!

... And reserves are almost totally useless in protecting these economies from the risks they face (and, no, no, no, reserves cannot be used to recapitalize the banks - only domestic government borrowing or direct or hidden taxes on the household sector can be used to recapitalize the banks). In fact, it was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity (sound familiar?). These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit.

The above case is most accurate in regards to China, where the accumulated reserves have come from preventing Yuan appreciation, rapid urbanization and rising worker productivity (which remains one of the key drivers for the country's exports). Thus, if we go by historical precedence, a huge financial reserve for China does not safeguard the country against a financial crisis.

These similar concerns are being supported by other analysts and economists. Trend forecaster Gerald Celente believes that the depression is global and a contraction across the entire planet cannot be avoided, and that includes China.

Economist Harry Dent holds a similar view, recently saying that, "China will see their bubble collapse strongly when the U.S.-led stimulus program fails due to rising defaults and foreclosures later in 2010, at the same time that the world is looking for China to pull it out of this global downturn."

As suggested above by Michael Pettis, though foreign reserves can be used for very specific forms of instability, there is one way in which China can use its reserves to tackle the current problem of rising domestic debt - by converting its foreign currency denominated assets (which is primarily U.S. dollar for China) to Yuan.

However, this would lead to appreciation of Yuan against the USD. With China being an export-driven economy, this is a measure of very last resort.

But eventually, China will have to appreciate Yuan as it is facing considerable international pressure from its trading partners, more importantly, it looks like the only way to ease strains on the country's fast growing economy. We feel that this will not be a voluntary move (China faces new pressure to let currency rise).

Disclosure: No positions as of now