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 throws of a
credit driven asset bubble, but its touted safeguards point the way to
drastic correction.


 

China 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, along 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 an 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
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 its 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.  

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, that is by converting its foreign currency denominated
assets (which is primarily 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).

 

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