Reading Chinese tea leaves

October 22, 2010

China’s GDP and Inflation figures for the quarter ending September are out . And they look promising indeed . GDP at 9.6% although a tad lower is still pretty impressive. Inflation at 3.6% per cent is a little more than August’s 3.5% .

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The figures mean that  China is growing robustly and the economy is not yet on the threshold of overheating . And this provides an interesting perspective to Tuesday’s interest rate hike by the Peoples Bank of China .

The 25 basis point interest rate hike, the first in three years ,  was in itself not a ground shaking event. But it had a huge psychological impact . Markets all over the world were spooked amidst fears that the world’s fastest growing economy is overheated and planning to curb growth .

Although the markets are right to worry about the overheating of Chinese economy, Tuesday’s move by the Central Bank ,like all things Chinese , was based on  much more complex, and political, reasons.

This rate hike is to be seen as a signal to US before the coming G-20 summit . One of the major argument proposed by US favouring a devaluation of the Yuan was based on the premise that a weak Yuan causes inflation in China , and in todays era of sluggish economic growth it is in China’s interest to let the Yuan appreciate rather than going for the more risky option of interest rate hike. China has hit back by doing the exact opposite.

China has let it be known that it has enough confidence in its growth to accept the risk of interest rate hikes. Tuesday’s cuts are a signal to the world that the China is not going to do much about its currency and would prefer to handle any inflationary pressures through domestic policies.

Impressive indeed . But behind all this nationalistic grandstanding , lurks a very real and potent danger to the Chinese miracle : a rapidly building asset price bubble. And  the Chinese leaders, who are busy proclaiming the resurgence of their nation and letting it be known to the whole wide world that China would not cave in to any external pressure ever again,  are doing precious little to tackle it.

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China is awash in money. As the great Chinese middle class becomes richer and richer, a boom mentality is setting in . Interest rates in the Chinese informal market are running at 20%, rates that were last seen during the dot com bubble in US. There is a mad rush towards the real estate sector. Couples are faking divorces to get past the “one house per  family” policy. High-end property prices in dozens of Chinese cities have doubled during the global financial crisis.   An asset price bubble, particularly in the real estate sector , appears to be rapidly building up.

Sooner or later this asset price bubble would spill over as inflation in the customer price index . Although, the September figures show only a marginal increase, there is a clear and persistent danger of inflationary trends in the Chinese economy.

Precious little is being done by the Chinese political mandarins to rectify the situation . Much of Chinese competitiveness , as this article points out , is based on low interest rates. The Chinese government is worried about the potential adverse effects any monetary tightening could have on this competitiveness. More worryingly, powerful political interests in China have vested interests in not letting the rates rise . Tuesdays interest rate hikes, by their relative ineffectuality, serve to demonstrate, at least for the time being,  the unwillingness of the government to tackle the situation head on .

But again , we must not rush to draw conclusions . One of the best strategy when dealing with the Dragon is patience. Let us wait and watch , because this could well turn out to be more complex than it seems .




There is war brewing. The guns are primed, the sights set, and the enemy marked.  The soldiers are jittery, and the atmosphere explosive. A rash action by either party could trigger a ferocious war causing untold mayhem .

No , I am not talking about Israel standoff with Iran. I am talking about the currency wars which government officials of both China and US are preparing to fight.

The innocuous sounding “H. R. 2378 — Currency Reform for Fair Trade Act” was passed by the US House of Representatives  by a vote of  348 to 79 on 28th of September .  The bill calls for the US Department of Commerce to start imposing – even without approval by US President Barack Obama — punitive tariffs on certain countries. The initiative specifically targets countries that have “a fundamentally undervalued currency,” “persistent global current account surpluses” and very large currency reserves – in other words, China.

Ahead of the impending elections and faced with massive unemployment and sluggish economy, the US politicians are baying for Chinese blood. They want to put and end to the deplorable Chinese practice of currency manipulation, which makes Chinese exports cheaper and causes US industries to shut shop.


Unequal Competition


But the Chinese are in no mood to oblige. They are determined not to suffer the same fate as Japan of the 1980’s. Under US pressure the Japanese were forced to let yen appreciate. Within one year, the value of the yen had increased by some 60 percent. In order to balance out the negative consequences of the revaluation for the country’s export industry, the Bank of Japan lowered interest rates to nearly zero, thereby triggering a huge speculative bubble on the stock exchange and the real estate market. Even today, Japan has still not recovered from the prolonged crisis that ensued.

And then there are political considerations.  The Chinese government, which has long positioned itself as crusaders to restore Chinese glory, cannot afford to lose face in front of their domestic constituency by bowing to Chinese demands.

So I guess, the Chinese won’t do anything except a slow and gradual revaluation of their currency, which gives time to their export industries to adjust.

Uncle Sam can now either it its own words or proceed with sanctions. Under Republican pressure and increasingly being branded as a weak president, Obama cannot afford to do nothing.  He would  go for sanctions. And then we can kiss free trade and the recovery of the world economy goodbye.

It would be like the 1920’s and 1930’s. European powers bent upon reviving their sluggish economies indulged in protectionist policies that ultimately led to a deflationary cycle and ultimately the Great Depression.

There is a lot at stake, and I am keeping my fingers advised. In the meantime I am buying gold , I will advise you do the same.


Gold prices


Despite everything, the Chinese economy has shown incredible resilience recently. Although its biggest customers — the United States and Europe — are struggling (to say the least) and its exports are down more than 20 percent, China is still spitting out economic growth numbers as if there weren’t a worry in the world. The most recent estimate put annual growth at nearly 8 percent.

Is the Chinese economy operating in a different economic reality?  Will it continue to grow, no matter what the global economy is doing?

The answer to both questions is no. China’s fortunes over the past decade are reminiscent of Lucent Technologies in the 1990s. Lucent sold computer equipment to dot-coms. At first, its growth was natural, the result of selling goods to traditional, cash-generating companies. After opportunities with cash-generating customers dried out, it moved to start-ups — and its growth became slightly artificial. These dot-coms were able to buy Lucent’s equipment only by raising money through private equity and equity markets, since their business models didn’t factor in the necessity of cash-flow generation.
Funds to buy Lucent’s equipment quickly dried up, and its growth should have decelerated or declined. Instead, Lucent offered its own financing to dot-coms by borrowing and lending money on the cheap to finance the purchase of its own equipment. This worked well enough, until it came time to pay back the loans.
The United States, of course, isn’t a dot-com. But a great portion of its growth came from borrowing Chinese money to buy Chinese goods, which means that Chinese growth was dependent on that very same borrowing.
Now the United States and the rest of the world is retrenching, corporations are slashing their spending, and consumers are closing their pocket books. This means that the consumption of Chinese goods is on the decline. And this is where the dot-com analogy breaks down. Unlike Lucent, China has nuclear weapons. It can print money at will and can simply order its banks to lend. It is a communist command economy, after all. Lucent is now a $2 stock. China won’t go down that easily.
The Chinese central bank has a significant advantage over the U.S. Federal Reserve. Chairman Ben Bernanke and his cohort may print a lot of money (and they did), but there’s almost nothing they can do to speed the velocity of money. They simply cannot force banks to lend without nationalizing them (and only the government-sponsored enterprises have been nationalized). They also cannot force corporations and consumers to spend. Since China isn’t a democracy, it doesn’t suffer these problems.
China’s communist government owns a large part of the money-creation and money-spending apparatus. Money supply therefore shot up 28.5 percent in June. Since it controls the banks, it can force them to lend, which it has also done.
Finally, China can force government-owned corporate entities to borrow and spend, and spend quickly itself. This isn’t some slow-moving, touchy-feely democracy. If the Chinese government decides to build a highway, it simply draws a straight line on the map. Any obstacle — like a hospital, a school, or a Politburo member’s house — can become a casualty of the greater good.
Although China can’t control consumer spending, the consumer is a comparatively small part of its economy. Plus, currency control diminishes the consumer’s buying power. All of this makes the United States’ TARP plans look like child’s play. If China wants to stimulate the economy, it does so — and fast. That’s why the country is producing such robust economic numbers.
Why is China doing this? It doesn’t have the kind of social safety net one sees in the developed world, so it needs to keep its economy going at any cost. Millions of people have migrated to its cities, and now they’re hungry and unemployed. People without food or work tend to riot. To keep that from happening, the government is more than willing to artificially stimulate the economy, in the hopes of buying time until the global system stabilizes. It’s literally forcing banks to lend — which will create a huge pile of horrible loans on top of the ones they’ve originated over the last decade.
But don’t confuse fast growth with sustainable growth. Much of China’s growth over the past decade has come from lending to the United States. The country suffers from real overcapacity. And now growth comes from borrowing — and hundreds of billion-dollar decisions made on the fly don’t inspire a lot of confidence. For example, a nearly completed, 13-story building in Shanghai collapsed in June due to the poor quality of its construction.
This growth will result in a huge pile of bad debt — as forced lending is bad lending. The list of negative consequences is very long, but the bottom line is simple: There is no miracle in the Chinese miracle growth, and China will pay a price. The only question is when and how much.
Another casualty of what’s taking place in China is the U.S. interest rate. China sold goods to the United States and received dollars in exchange. If China were to follow the natural order of things, it would have converted those dollars to renminbi (that is, sell dollars and buy renminbi). The dollar would have declined and renminbi would have risen. But this would have made Chinese goods more expensive in dollars — making Chinese products less price-competitive. China would have exported less, and its economy would have grown at a much slower rate.
But China chose a different route. Instead of exchanging dollars back into renminbi and thus driving the dollar down and the renminbi up — the natural order of things — China parked its money in the dollar by buying Treasurys. It artificially propped up the dollar. And now, China is sitting on 2.2 trillion of them.
Now, China needs to stimulate its economy. It’s facing a very delicate situation indeed: It needs the money internally to finance its continued growth. However, if it were to sell dollar-denominated treasuries, several bad things would happen. Its currency would skyrocket — meaning the loss of its competitive low-cost-producer edge. Or, U.S. interest rates would go up dramatically — not good for its biggest customer, and therefore not good for China.
This is why China is desperately trying to figure out how to withdraw its funds from the dollar without driving it down — not an easy feat.
And the U.S. government isn’t helping: It’s printing money and issuing Treasurys at a fast clip, and needs somebody to keep buying them. If China reduces or halts its buying, the United States may be looking at high interest rates, with or without inflation. (The latter scenario is most worrying.)
All in all, this spells trouble — a big, big Chinese bubble. Identifying such bubbles is a lot easier than timing their collapse. But as we’ve recently learned, you can defy the laws of financial gravity for only so long. Put simply, mean reversion is a bitch. And the longer excesses persist, the harder the financial gravity will bring China’s economy back to Earth.