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China's Fragile Economy, Its Housing Bubble, and What It Means To Us: Part III

We think that China is an indestructible economic juggernaut but its economy is very fragile and it is sitting on a property bubble which will burst. What China does in response has major implications for their economy and the rest of the world. This is the third part of a three-part series on this topic

Inflation is on the Rise

I think they will panic if they see western economies weaken. They will panic further if real estate prices start to collapse as a result of tightening policies and western economies weaken. The panic will result in more fiscal and monetary stimulus.

This is right out of the Keynesian playbook and the result will feed the bubble, create inflation, and result in more debt. And, since a substantial part of their official "growth" comes from quasi-government entities (local  and regional governments, Red Army and other State-run enterprises) which are highly inefficient as a result of top-down dictates from Beijing, much of this spending is just a waste of capital. Japan tried the same thing and it didn't work for them either.

It is remarkable that Premier Wen can get up and say that China will have 8% growth this year. In light of poor exports, a financial bubble, poor internal demand, and the severe risk from  the quasi-government and local government debt bomb, it is unlikely that China will see real economic growth this year approaching that number. Understand that they can claim to have such growth because of how they measure GDP, but it isn't real.

And they are already seeing  inflation. In February consumer prices rose 2.7% YoY, a 16-month high. Producer prices rose 4.3% in January and 5.4% in February. In light of money supply targets, inflation can only grow. The fact that there is an "output gap" has nothing to do with inflation; idle capacity and high inflation are compatible (remember stagflation). The government's target is to keep it under 3%. No one believes that.

It is clear that, officially, the CPI won't exceed 3%, but unofficially? There will be no way to know for sure. I doubt they will announce price controls to achieve their goal, but they have the power to do it unofficially by either fudging the numbers or "jawing" prices down, or both. If they attempt de facto price controls, the evidence of such will be shortages of certain commodities.

The Consequences to China and the World

1. China will lead no one out of the recession. Despite what many commentators tell you, China has weak internal consumption and lives on exports. We cannot look to them to be a leader of the world’s economies because they live off of the U.S., Europe, Japan, and other buyers of Chinese products. The U.S. will lead them out of the recession, not vice versa. The only way they can rapidly spur internal consumption is for them to abandon their wasteful planned economy, fully embrace capitalism, and let those who know how to create wealth and jobs do their thing.

2. The last thing they will do is let the yuan rise. The government is worried about the recovery of western consumer economies. In twoblockbuster statements coming out of Beijing last Saturday (March 13) and Sunday (March 14),  He Keng, vice chairman of the Financial and Economic Committee of the National People’s Congress, and Premier Wen Jiabao, said that they are worried about a double-dip global recession. This is an entirely new position China has taken on the recovery. This means also that they are more likely to increase fiscal and monetary stimulus. Maintaining the yuan may be easier when hot money bails out of their markets (maybe $25 billion flowed into China's bubble).

3. China will not seriously tighten money and credit. They will continue to inflate to try to stimulate internal consumption and let inflation bail them out of the huge liabilities they face from massive defaults of local governments, quasi-government entities, and state-run enterprises. Even if they were serious about bursting the real estate bubble, they won't because they know the economy will tank because the bubble was built on cheap money, courtesy of the People's Bank of China, not real demand.

4. They have another incentive to inflate: to maintain the "stability" of the yuan. Since China's leaders are clearly worried about a double-dip recession, there is pressure on them to stimulate exports, the mainstay of their economy. Letting the yuan rise will defeat that purpose. They can flood the market at will with new yuan and also use its reserves to sell yuan. Since they are cutting back slightly on purchases of U.S. Treasuries, they have the cash to control the yuan market.

5. The real estate bubble will burst ... eventually. There is no period in history when such bubbles have not ended badly. I recommend Rogoff and Reinhart's paper, "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises." While I disagree with many of their economic assumptions, they offer a fascinating look at debt-fueled crises throughout history. Their conclusion: bubbles inevitably crash. They just came out with a book based on this paper.

6. When the bubble bursts, the results will be severe. You will recall that most of last year's economic activity came from real estate. According to Yi Xianrong, a researcher at the Chinese Academy of Social Sciences’ Finance Research Center, mentioned above, "our economy growth will stop". Or you could listen to economist Ken Rogoff who believes such a crash could reduce their GDP to 2%. Rogoff doesn't offer much guidance on this other than to say it could happen in the next ten years.

7. What will happen to China after the crash is that they will be left with a situation similar to the U.S. where home prices collapsed, taking down many financial institutions, developers, and perhaps wiping out the equity of many home buyers. But ... things are different in China, so it will be difficult to assess. For example, most buyers put very high down payments (about one-half) into a property. Also, the government will do what it can to bailout local governments by selling bonds to turn short-term obligations into long-term debt. Such activities by the government will only delay a recovery.

8. Their recovery will be prolonged. They cannot grow substantially without a recovery in exports.  And that requires a recovery of the economies of their customers, mainly the U.S., Europe, and Japan. I believe we will see a double-dip recession in the U.S. U.S. consumption will continue to be restrained as consumers worry about the economy, their jobs, their high debt, their declining asset values, and their inability to retire on schedule. Consumers will protect themselves by increasing savings. And that won't result in a huge increase in consumption. The consequences of a flattening of our economy will be bad for China.

9. They will have no real growth in internal consumer demand. The problem is that most of the new homes being built are aimed at the "rich" who are the main drivers of consumerism in China. When their housing asset base collapses, there will be a slowdown in internal consumption.

10. The government will be tempted to inflate even more to foster a recovery. Whether capital will continue to flow into real estate is a question mark. While that is possible, and perhaps investors there have short memories, it is more likely that capital will flow into other areas. As prices rise, look for assets to flow into the stock market, and commodities, especially gold. We may see a continuation of central bank purchases of gold that they started in April, 2009. A sure sign of inflation and the government's attempt to control prices will be shortages of goods. 

Disclosure: No positions