naked capitalism

Has the Chinese export sector become hostage to WalMartization, the ability of powerful retailers to squeeze vendor profit margins? Reader Michael Q called our attention to a key remark in a Wall Street Journal story:

Vice Commerce Minister Zhong Shan, in an exclusive interview Thursday ahead of a visit to the U.S., said that the profit margin on many Chinese export goods was less than 2%.

Most exporters absorbed the appreciation in the value of the yuan that followed its revaluation in 2005 by boosting innovation and cutting costs, but many were forced to close, he said. A further rise in the currency’s value would endanger more exporters’ survival, which China can’t afford, he said.

As Michael Q, who is an equity analyst, noted:

2% margins on export-oriented businesses is not representative of any sort of real competitive advantage. A real competitive advantage when it comes to exporting would show double-digits profit margins. This whole sector is hanging by a thread…nearly none of the activity China has engaged in since the downturn is secular or self-sustaining.

Yves here. The implications for China are serious. First, this says that it perceives it has no room to revalue the RMB upwards. Not only are exporters politically powerful, but on a more mundane level, the regime has achieved social cohesion through a promise of rising prosperity. Too much unemployment would undermine the legitimacy of the governing classes.

But second, it also implies China cannot even tolerate much inflation. Remember, inflation will push up the price of good in local currency terms, which in a fixed peg currency regime, translates directly into price increases. Price increases from a country whose selling proposition is cheap prices would lead importers to look for substitutes in other emerging economies. A 2% margin not only says manufacturers have no room to cut prices, it also says they cannot afford much in the way of lost revenue.

This dynamic makes the idea floated on the blog earlier, that China might devalue the RMB, less radical than it might seem.

A post by Edward Harrison

In reading Scott Sumner’s take on the China currency peg dilemma, I see that both he and Paul Krugman hit on the fundamental problem in the debate: reserves. Everyone is talking about the peg as if relaxing the peg will be the magic bullet to America’s current account problem. But this is clearly not the case.

If China were to unilaterally revalue it’s currency, the Chinese would start buying fewer dollars incrementally. Part of the benefits of revaluation would accrue to Chinese export competitors in Europe (principally Germany) and in Asia (depending on their currency policy response). As US economic policy would be unchanged, US imports would switch from China to its competitors without any benefit accruing to the US.

If the Chinese revalued, but then also bought euros, selling dollar assets, a Yuan revaluation would effectively be a US dollar depreciation against both the Yuan and the euro (not to mention against other Asian countries again depending on whether they move in concert with the Chinese). In this case, the US would be able to reduce its current account deficit. (**Note: I changed this section to more accurately reflect the mechanics.)

Either way, the policy aim appears to be to force the Chinese to effect a US dollar depreciation – and this is what has the Chinese so outraged.

The Wall Street Journal quotes China’s Premier Wen as saying:

“I can understand that some countries want to increase their share of exports,” Mr. Wen said, in an apparent reference to the Obama administration’s goal. “What I don’t understand is the practice of depreciating one’s own currency and attempting to press other countries to appreciate their own currencies solely for the purpose of increasing one’s own exports,” he added. “This kind of practice I think is a kind of trade protectionism.”

It is not the peg that matters. This is the symptom.  It is China’s accumulation of reserves – it’s capital account surplus – which are at issue. Krugman has it right when he says:

…the right way to think about China’s exchange rate is, initially, not to think about the exchange rate. Instead, you should focus on China’s currency intervention, in which the government buys foreign assets and sells domestic assets, on a massive scale.

Ostensibly, this is the same issue the US should have with Japan since they also have been accumulating an enormous amount of US dollar reserves. But, no one is talking about this because the Japanese have a floating currency. In reality, what is at work here is a high savings rate – a high private sector balance – which is not met by an equivalent government sector deficit. The differential therefore shows up as a capital account deficit aka trade surplus.

Let me illustrate how this works across a number of countries using a chart I showed you when discussing the financial sector balances in Europe last week.

As you can see in the diagram, the Netherlands, Germany, Austria and Finland are the only countries depicted with capital account deficits. In each case, the countries have very large private balance surpluses (Finland to a lesser degree). Also, in each case, the government deficits are smaller than their private surplus. Hence, the capital account deficit.

However, if you look at Ireland, now in a depression, their huge private savings rate is more than offset by the budget deficit. Hence, the capital account surplus (trade deficit).

How do we resolve this problem? On some level, this is a political problem more than anything else.  Take Ireland, for example. Why shouldn’t they have high private sector savings? After all, they accumulated lots of private sector debts during the housing bubble. In their case, they cannot devalue because they are locked into the eurozone. The only way the Irish can run a trade surplus is through an internal devaluation aka an across the board wage and salary cut. This would make Irish exports more attractive, improving their trade balance and cutting their budget deficit.

But, that’s never going to happen in isolation. What will happen is the Irish will cut their budget deficit by cutting expenditure. This will precipitate a decrease in private savings and greater levels of debt distress along with the lower GDP the cuts entail.

So, what about the Chinese (or the Japanese) then? How do we get them to stop accumulating reserves. One way is to revalue their currency. But for fear of the repercussions in the domestic export economy, this is likely to happen slowly. Another way, would be to decrease stimulus, putting the government into a surplus position. In China’s case, this is promising. Signs of overheating are everywhere. The Chinese needs to reduce excess fixed capital investment. I am assuming this policy would reduce government support of export industries giving it a double effect on savings. Since exports are the issue abroad, that would make sense.

The last possibility then is to encourage less saving and more spending. However, this could prove a tough nut to crack as well. For one, Shang-Jin Wei, a Professor of Finance and Economics at Columbia University’s Business School, thinks the high savings rate has much to do with the one-child policy.

He writes:

There are approximately 122 boys born for every 100 girls today, a ratio that translates into cutting about one in five Chinese men out of the marriage market when this generation of children grows up…

“The increased pressure on the marriage market in China might induce men and parents with sons to do things to make themselves more competitive,” Wei says. “Increasing savings is one logical way to do that, to the extent that wealth helps to increase a man’s competitive edge. Parents increase household savings mostly by cutting down their own consumption.”

Wei worked with Xiaobo Zhang of the International Food Policy Research Institute in Washington, D.C., to see if his hypothesis held up, comparing savings data across regions and in households with sons versus those with daughters. “We find not only that households with sons save more than households with daughters in all regions,” Wei says, “but that households with sons tend to raise their savings rate if they also happen to live in a region with a more skewed sex ratio.”

The effect is significant. The household savings rate in China rose from about 16 percent of disposable income in 1990 to over 30 percent today, which is much higher than most countries. About half of the increase in the savings rate of the last 25 years can be attributed to the rise in the sex ratio imbalance. “It’s a very high ratio of savings to income,” Wei says. “The comparable savings rate in the United States would be 2 or 3 percent before the crisis, and about 6 percent since the crisis.”

Even those not competing in the marriage market must compete to buy housing and make other significant purchases, pushing up the savings rate for all households.

“While the conventional explanations for the high savings rate all play a role, they are not as important as people previously thought,” Wei says.

I am not sure what kinds of (gender-based) consumption incentives one could offer to induce more spending. But, the gender skew will be with us for some time. Chinese policy makers need to do anything they can to encourage greater spending. In particular, Chinese policy makers could think about incentives that increase the marginal propensity to spend in families with male children. In concert with a slow revaluation, this will certainly alleviate much of the trade imbalance now causing so much discussion.

A post by Edward Harrison

I am going to talk here a little bit about the looming trade war between China and the United States. But I am going to come at it from a side angle via some historical analogies.

Common folklore in the United States says that the Soviet Empire collapsed in large part due to the efforts of American President Ronald Reagan and not due to internal forces. Others downplay Reagan’s role and see internal forces as more significant.

I want to briefly outline this debate and make a parallel to the financial crisis and the near collapse of the American financial system and ask a few questions about anti-Chinese protectionist rhetoric in this context. My basic question will be: How effective is external pressure in precipitating regime change or economic policy moves?

Let’s start off with the collapse of the Soviet Union. When Ronald Reagan died in June 2004, MSNBC ran an article, “Determination to destroy communism was a hallmark of his 8-year presidency” which eulogized the former President with credit for helping to destroy the Soviet Empire.

The article began:

He stunned the Soviet Union with his tough rhetoric, calling it an “evil empire” whose leaders gave themselves the “right to commit any crime.”

His famed “Star Wars” program drew the Soviets into a costly arms race it couldn’t afford. His 1987 declaration to Soviet leader Mikhail Gorbachev at the Berlin Wall — “Mr. Gorbachev, tear down this wall” — was the ultimate challenge of the Cold War.

Ronald Reagan’s determination to destroy communism and the Soviet Union was a hallmark of his eight-year presidency, carried out through a harsh nuclear policy toward Moscow that softened only slightly when Gorbachev came to office.

He is vividly remembered in Russia today as the force that precipitated the Soviet collapse.

“Reagan bolstered the U.S. military might to ruin the Soviet economy, and he achieved his goal,” said Gennady Gerasimov, who served as top spokesman for the Soviet Foreign Ministry during the 1980s.

The article goes on to assert that Reagan’s anti-Soviet stance was a significant departure from Jimmy Carter’s ‘mild detente’ [read: weak on defense], suggesting that this course change brought down the Soviet Union.  The article then provides yet more quotes from influential Russian dissidents to bolster this claim.

But is this really true?

Last November, an online survey demonstrated that Americans are alone in this view that external pressure applied by the Reagan Administration was principally responsible for the Soviet collapse.

The online survey of representative national samples asked respondents to assess the performance of nine political figures of the 1980s, and their effect in the eventual collapse of communism.

For Americans, Reagan is the clear winner with 69 per cent of respondents claiming he deserves a lot of credit or some of the credit for the collapse of communism. More than half of people in the U.S. also commend Gorbachev (56%) and British Prime Minister Margaret Thatcher (57%) for their efforts.

In Britain, only Gorbachev (57%) and Walesa (56%) clear the 50 per cent mark, followed by German chancellor Helmut Kohl (47%), Thatcher (45%) and Reagan (44%).

In Canada, Gorbachev is seen as the most important figure (65%), followed by Reagan (58%), Thatcher (56%) and Walesa (52%). Canadians are more likely to select Reagan and Thatcher as deserving “some of the credit”, and place former Canadian Prime Minister Brian Mulroney at the bottom of the list with 25 per cent.

The survey also shows that a considerable proportion of people in the two North American countries (47% in the U.S. and 44% in Canada) regard Pope John Paul II as an important player in the collapse of communism, while Britons (31%) are decidedly more skeptical.

-People Differ on Who Deserves Credit for the Collapse of Communism, Vision Critical

On some level, it’s irrelevant if the claim that Ronald Reagan ended communism is true because the winners get the spoils. And that means they get to impose their historical narrative on past events whether this narrative is true or not.

If external pressure did bring down the Soviet Union, an analogous claim could be made for the American financial system’s near-collapse because of the focus by regulators post-9/11 on terrorism to the exclusion of financial fraud.

Last month, Bill Black, a former S&L crisis regulator gave a speech on mortgage fraud and its central role in the housing bubble and bust. he asserts that lax regulation was at the core of why this fraud was allowed to occur. What I found interesting about Black’s lecture was the section on the FBI. He starts by commenting that the FBI gave a prescient warning in September 2004 in Congressional testimony that fraud and insider trading were rampant in the mortgage market. Black says:

[The FBI] didn’t simply warn there was an epidemic of mortgage fraud, they explicitly warned that it would produce an economic crisis if it were not dealt with. So what was done in response to a warning that clear?

Not a whole lot. In fact, Black says no one wants to unearth the fraud because the majority of it came from the lenders and not the borrowers. This is a bit like the 9/11 intelligence memo warning of an imminent al Qaeda attack:

RICE: I remember very well that the president was aware that there were issues inside the United States. He talked to people about this. But I don’t remember the al Qaeda cells as being something that we were told we needed to do something about.

BEN-VENISTE: Isn’t it a fact, Dr. Rice, that the August 6 PDB warned against possible attacks in this country? And I ask you whether you recall the title of that PDB?

RICE: I believe the title was, "Bin Laden Determined to Attack Inside the United States."

Now, during the S&L crisis there were 1000 investigators on the case. In 2009 there were 150 FBI agents on the case. And that’s a large part of the problem. After 9/11, more than 500 white-collar investigative specialist FBI agents were transferred from white-collar crime to focus on national security. Had these 500 extra FBI agents been available, perhaps the fraud would have been prosecuted. Similar tales are certainly available at other regulators like the SEC as the U.S. was more interested in connecting charities to terrorist sources than investigating mortgage fraud.

So, in a very real sense, one could make the same argument about 9/11 and al Qaeda causing the collapse of the United States’ financial system  that is made about Reagan causing the collapse of the Soviet economic system. I do not find this line of thinking persuasive. But, the situations are indeed analogous.

So, here’s my question again: How effective is external pressure in precipitating regime change or economic policy moves?

We see that most Americans believe it was very effective in bringing down the Soviets. Most believe it was effective in ending Apartheid in South Africa. It has not been so successful in Cuba or North Korea. But could external pressure work in Iran or even in China?

My general take is no; politicians, especially in command economies, are relatively unconcerned with external pressure. I used to be a foreign policy specialist. And, despite my role, I was keenly aware of the primacy of domestic issues over foreign ones in a politician’s decision-making. What the ruling elite in command economies care about is social unrest that stems from a lack of civil liberties and economic progress. Even in the United States, this is true.  Do you think American politicians will yield to Brazilian threats to retaliate for American cotton subsidies? Of course not.

Threats don’t work. The only thing that can work is inflicting economic pain and creating social unrest. Yes, autarky hasn’t brought the North Koreans or Cubans to heel; nor did it topple Saddam Hussein. However, implicitly, this is the power that some American political historians ascribe to the policies against South Africa and the Soviets. They assert that it was the economic pain that caused those governments to eventually yield.

So, as Americans look to threaten to punish China for China’s protectionist exchange rate policy, we should all understand that these threats will have no effect.  The Chinese will not do anything because of threats. More likely, they will dig in their heels. The Telegraph’s Liam Halligan has it right when he says:

When it comes to China, the West needs to face the truth. The more America calls for China to revalue the longer Beijing will take to do it. Chinese politicians are as unlikely to buckle in the face of Western pressure as their Western counterparts would be given a tongue-lashing from Beijing.

China’s government is petrified of social unrest. Given the importance of the export sector for continued high growth and jobs, this again makes it impossible to Beijing to be seen yielding to pain imposed by the West.

What is more likely to occur is that American politicians, pressured by the upcoming mid-term elections, will create binding legislation to retaliate against China for their undervalued currency. China will not budge – in part out of pride and in part out of need to prevent a hard landing. As a result, the binding legislation will become operative and a trade war will ensue.

For more on how a trade war would affect the global economy read Michael Pettis’ piece How will an RMB revaluation affect China, the US, and the world?. He notes that surplus countries like China have the most to lose and feels that the short-term losses for the U.S. will be less. I agree that surplus nations have the most to lose. But I disagree about the short-term effects on the United States; any economic shock to the United States will tip into a double dip recession, precipitating higher unemployment, a renewed meltdown in the financial sector and the attendant deleveraging. That is very bearish for equities, I should add. Moreover, the Chinese would make their UN Security Council veto work and stymie any efforts the U.S. makes toward controlling Iran. I see a lot more risk in a Chinese trade war for the United States than Pettis.

This is what I have labelled Murder-Suicide in Chimerica. But, I believe this could be where we are headed -  now more than ever.

The Financial Times’ Martin Wolf gives a cogent and sober assessment of what he deems to be a destructive refusal to adjust policies on behalf of the world’s two biggest exporters, China and Germany. The problem is that both simultaneously want to have their cake and eat it too.

As we stressed in a recent post, large foreign exchange surpluses, beyond what is useful to defend a currency, is NOT a sign of strength. They cannot be spent without causing the currency to appreciate, something that surplus-dependent countries are unwilling to do. Thus these holdings, which were incurred by acting as de facto export subsidies, cannot be utilized without serving as import subsidies. As Wolf elaborates:

China and Germany are, of course, very different from each other. Yet, for all their differences, these countries share some characteristics: they are the largest exporters of manufactures, with China now ahead of Germany; they have massive surpluses of saving over investment; and they have huge trade surpluses.

Both also believe that their customers should keep buying, but stop irresponsible borrowing. Since their surpluses entail others’ deficits, this position is incoherent. Surplus countries have to finance those in deficit. If the stock of debt becomes too big, the debtors will default. If so, the vaunted “savings” of surplus countries will prove to have been illusory: vendor finance becomes, after the fact, open export subsidies.

Wolf stresses that this posture is a threat to open trade and the eurozone. Wolfgang Munchau parsed the so-called Schäuble proposal yesterday:

I was confused when Wolfgang Schäuble, German finance minister, proposed a European Monetary Fund….. I realised that the EMF is just a smokescreen. The real bullet in his proposal is that countries could leave the eurozone without leaving the European Union. This is not about helping countries in trouble. This is about helping them to get out.

The political message of the Schäuble plan is that Greece will be the last bail-out ever. As preparations for a bail-out reach an advanced stage, the German public reaction has become progressively more hostile. If the Schäuble plan had already been in place, Greece would already have headed to the exit. It is hard to conceive of a situation under the plan where a country simultaneously fulfils the criteria for aid, and needs it.

Wolf today teases out the implications:

Three points can be drawn from this démarche from Europe’s most powerful country: first, it will have an overwhelmingly deflationary impact; second, it is unworkable; and, third, it might pave the way for Germany’s exit from the eurozone.

I explained the first point last week. If Germany gets what it wants, the world’s second-largest economy would play an altogether negative role in the search for a way out from the global slump in aggregate demand. The eurozone would not be exporting the demand the world now needs. It would export excess supply, instead.

Imagine that weaker eurozone countries were forced to contract their fiscal deficits sharply. This would surely weaken the entire eurozone economy. But the result would also be fiscal deterioration in Germany and France. Imagine that Germany then did don the hair shirt. Would it instruct France to do the same? After all, France already has a general government deficit forecast by the Organisation for Economic Co-operation and Development at close to 9 per cent of gross domestic product this year. Does Mr Schäuble imagine France could be fined? Surely not. Yet it is not Greek public finances that threaten the stability of the eurozone. These are a mere bagatelle. The threat is the public finances of big countries. Since Germany could not force such countries to behave and has no chance of expelling any member it disapproves of from the eurozone, it would have to leave itself. That is the logic of Mr Schäuble’s ideas. This must be obvious to him, too.

Yves here. Rob Parenteau, in a series of posts (here and here) explained longer-form, in the case of Spain, why adhering to austerity targets looked certain to produce a sharp economic contraction. Back to Wolf:

Germany is in a supposedly irrevocable currency union with some of its principal customers. It now wants them to deflate their way to prosperity in a world of chronically weak aggregate demand. Mr Wen has the same idea. But the economy he wants to pursue this goal is the US. Fat chance!

Speaking at the end of the National People’s Congress, Mr Wen declared: “What I don’t understand is depreciating one’s own currency, and attempting to pressure others to appreciate, for the purpose of increasing exports. In my view, that is protectionism.” He also insisted he was worried about the safety of China’s dollar investments.

What, I wonder, does Premier Wen mean by this, apart from telling the US to leave China’s exchange rate policies alone? If the US desire for a weaker dollar is “protectionist”, how much more so is China’s determination to keep its currency down, come what may? There is nothing evidently “protectionist” about asking a country with a huge current account surplus to reduce it, at a time of weak global demand. If I understand China’s declared position correctly, it wants the US to deflate itself into competitiveness, instead, via fiscal and monetary contraction and, presumably, falling domestic prices. That would be dreadful for the US. But it would be dreadful for China and the rest of the world, too. It is also not going to happen. China surely knows that.

Yves here. I am not sure Wen does. Per Upton Sinclair: It is difficult to get a man to understand something when his salary depends upon his not understanding it. Back again to Wolf:

Behind all this is a fundamental divide. Surplus countries insist on continuing just as before. But they refuse to accept that their reliance on export surpluses must rebound upon themselves, once their customers go broke. Indeed, that is just what is happening. Meanwhile, countries that ran huge external deficits in the past can cut the massive fiscal deficits that result from post-bubble deleveraging by their private sectors only via a big surge in their net exports…..

In this battle, the surplus countries are most unlikely to win. A disruption of the eurozone would be very bad for German manufacturing. A US resort to protectionism would be very bad for China. Those whom the gods wish to destroy, they first make mad. It is not too late to look for co-operative solutions. Both sides have to seek to adjust. Forget all the self-righteous moralising. Try some plain common sense, instead.

Yves here. This battle of wills is rooted on every front in domestic politics, plus a collective inability to recognize that our current version of globalization is no longer workable. But we appear likely to test the current system to destruction rather than come up with less drastic ways out.

A post by Edward Harrison.

I was talking to a friend of mine who does emerging market investing for a living and I asked him what he made of recent China-bullish comments by Stephen Roach. 

The Morgan Stanley Asia head was in Germany speaking to German business daily Handelsblatt last week. The guys from Handelsblatt wrote up a piece called “In China bildet sich keine Blase an den Märkten” which translates “China is not creating a market bubble.” Unfortunately, the story is behind a pay wall (and it’s in German anyway). But Gwen Robinson of the FT got the inside scoop and posted “Roach: Pooh-pooh to Chinese bubbles” at FT Alphaville. She writes:

As Roach notes, the Shanghai A-share composite index soared 3.5 times in the year ending October 2007 before plunging more than 70 per cent in the ensuing 12 months.

And every China watcher knows about the surge in nonperforming bank loans that required a major recapitalization of a nascent Chinese banking system less than 10 years ago.

But these problems were mere bumps in the road, in retrospect. Roach explains (our emphasis):

That’s because Beijing was vigilant in preventing asset and credit bubbles from spilling over into the real side of the Chinese economy. This was very different from the Japan endgame of the late 1980s, where the confluence of equity and property bubbles led to a massive overhang of excess capacity.

What’s more, he adds, it stands in sharp contrast to the more recent US experience, where property and credit bubbles pushed up homebuilding and personal consumption to nearly 80 per cent of US GDP prior to the bursting of the subprime bubble.

Of course, China is “hardly the poster child of macro stability” – with exports and fixed investment surging to nearly 75 per cent of Chinese GDP and private consumption at 35 per cent and still falling, China’s macro imbalances are in a league of their own.

But in Roach’s view, these distortions are less of an outgrowth of asset and credit bubbles and more a by-product of a conscious strategy of externally-oriented economic development.

While China can hardly avoid bubbles, he notes, it has been successful in preventing them from destabilising the real economy.

Because of the spate of China currency manipulation/protectionism stories hitting the wires (see my links post), I had been thinking about 1931 a lot recently – more on that later. But when I asked my friend what he thought of Roach’s comments, he said: “I think China is indeed Japan in 89/90, but potentially magnified.”

Let me explain. Contrary to current folklore, the reign of Paul Volcker was not one of extreme inflation hawkishness and anti-bubble moral suasion. In fact, there were serious animal spirits building in the U.S. in part due to a September 1985 Plaza Accord, in which the major countries all agreed to depreciate the US dollar. The exchange rate plunged a fantastic 51% before the carnage was done. And as anyone will tell you, currency depreciation is inflationary – either for consumer prices or asset prices or both.

By February 1987, the U.S. Government was alarmed at the speed of the U.S. dollar’s depreciation and looked to reverse it at the Louvre Accord. The problem, however, was that the U.S. wanted Japan to continue a stimulative monetary policy. Here’s what the accord actually said:

The Government of Japan will follow monetary and fiscal policies which will help to expand domestic demand and thereby contribute to reducing the external surplus. The comprehensive tax reform, now before the Diet, will give additional stimulus to the vitality of the Japanese economy. Every effort will be made to get the 1987 budget approved by the Diet so that its early implementation be ensured. A comprehensive economic program will be prepared after the approval of the 1987 budget by the Diet, so as to stimulate domestic demand, with the prevailing economic situation duly taken into account. The Bank of Japan announced that it will reduce its discount rate by one half percent on February 23.

The Plaza Accord may have helped correct imbalances, but it also put the Japanese economy into a blow off bubble top that sent the Nikkei into the stratosphere above 38,000. The result was a spectacular bust from which Japan has still not recovered.

So, now that we see the Chinese, with their $600 billion stimulus package and massive increase in credit, causing serious malinvestment, one wonders whether we are seeing a repeat of the 1989/90 excess in Japan.

I have repeatedly pointed to enormous levels of malinvestment in China. Here are a few posts of that ilk.

• Hugh Hendry: China – The Emperor has no clothes Jul 2009
• China’s empty city: the emperor really has no clothes Nov 2009
• The Chinese bubble economy Jan 2010
• Construction in China’s Ghost Towns Jan 2010
• Jim Chanos still bearish on China, talks malinvestment Feb 2010

Yet, we see Stephen Roach’s cogent defence of what is going on in China. He is not known as a perma-bull – - quite the contrary.

So what gives? Is China experiencing a massive bubble or not? If so, will the bubble’s inevitable pop spill over into the real economy in a nasty way as it has done in the U.S. and elsewhere?

These are important questions given the central role China plays in the world economy. My own point of reference has been the 1920s and the 1930s more than the 1980s and 1990s. In the 1920s, Great Britain played the role now played by the United States: military power, declining economic power, anchor global currency, and largest debtor nation. The United States played the role now played by China: rising economic and military power and ‘alpha creditor,’ a phrase our Yves Smith coined. (The key difference is that the U.S. was more advanced relative to Great Britain than China relative to the U.S.)

The section in Charles Kindelberger’s seminal book, “The World in Depression 1929-1939″ on French accumulation of sterling also bears noting. Sterling was weak and the French had been accumulating huge amounts of British pound foreign reserves in 1926. This created a problem for the British because the French could threaten to redeem those pounds for gold under the gold standard then in operation. Kindelberger says:

this accumulation put [French central banker] Moreau in a strong position and [British central banker] Norman in a weak one. As an opening gambit, the bank of France began to convert sterling into gold…

There were threats of further conversions of sterling into gold.

Eventually, the French and British reached a compromise which involved the Federal Reserve Bank of New York lowering interest rates to help the British (and the Germans who had just had their travails with hyperinflation).  The result of this easy money was a blow-off top to the U.S. stock market and credit bubble that had almost collapsed after the Florida real estate boom went off the rails.

When I first posted this yesterday at Credit Writedowns, I failed to mention how I see China [and Japan] as the modern-day reserves accumulator. China is effectively doing what France did by accumulating reserves despite fears of currency depreciation. I think this reserve policy is significant because this is what is behind all of the talk of protectionism and currency pegging. The Chinese are afraid that the U.S. are actively looking to devalue the currency while the U.S. are fed up with the peg and the resultant imbalances.

How this gets resolved, I don’t know. Roach, at a minimum, usually points to increasing Chinese domestic demand (especially via increasing income security by expanding the social safety net). This parallels the situation in Europe where the Germans could increase spending to reduce intra-Eurozone imbalances, something France’s finance minister is on to. As for the Chinese, if they don’t do this, we are headed for some serious protectionist escalation in my view. And, as Ambrose Evans-Pritchard points out, the surplus countries take it on the chin in such a scenario, something we saw in Japan and Germany in 2008.

Clearly, the U.S. role of easy money global saviour in the late 1920’s was played by Japan in the late 1980’s and by China in the late 2000’s. Each time, the speculative mania which the easy money fuelled ended in disaster. 

Eventually, the whole system broke down in the 1930s, with the U.S. playing the protectionist card and precipitating collapse.

I have trouble believing this time is any different. If any of you have a different take on these events -especially in regards to protectionism, please respond in the comments.

Sources

Statement of the G6 Finance Ministers and Central Bank Governors (Louvre Accord) – University of Toronto G8 Information Centre

Charles Kindelberger – The World in Depression

Relations between the US and China have been deteriorating. Although both sides have poked each other in various ways (Obama meeting with the Dalai Lama, China dissing Obama in Copenhagen by standing him up for a meeting, some tit for tat on tariffs), the major, unresolved bone of contention is China’s pegging of its currency, the renminbi, at a level most experts deem to be undervalued. This has widespread ramifications: a continuation of global imbalances (one of the causes of the financial crisis) and preserving Chinese employment at the expense of its trading partners.

The US has strengthened its push for China to Do Something about the renminbi, meaning revalue it, with Obama calling for a “more market-oriented exchange rate”. Some analysts have forecast a rise of 5% this year. But the noise out of Beijing suggests otherwise. From Bloomberg:

Chinese Premier Wen Jiabao rebuffed calls for the yuan to appreciate, risking a further downturn in relations with the U.S. where lawmakers and economists say his stance is hampering a global recovery.

“I don’t think the renminbi is undervalued,” Wen said yesterday at a press conference in Beijing marking the end of China’s annual parliamentary meetings, using another term for the yuan. “We oppose countries pointing fingers at each other and even forcing a country to appreciate its currency.”

Yves here. The reason this issue is coming to the forefront now is twofold. One is that the Obama administration’s falling poll ratings are forcing it to address a central issue that it has neglected, namely, unemployment. The measures so far, a stimulus packages that most economists deem to be inadequate, and extending unemployment benefits, have simply blunted the severity of the problem rather than solved it. A cheaper dollar would bring jobs back to the US (in fact, manufacturers like Caterpillar have already started repatriating jobs. And before readers start arguing in favor of cheap Chinese labor, most firms who have outsourced and offshored have found cost savings to come up well short of expectations. Why? First, labor costs are a relatively small component of most manufactured goods. Even in a supposedly-hopeless-for-advanced-economies field like apparel, some US manufacturers like American Apparrel are paying $12-$13 an hour for workers who make T-shirts and sweatshirts, supposedly commodity items, and still show a profit). Sending work overseas greatly increases administrative costs, which involves much higher paid workers, along with higher shipping and inventory financing costs).

Two is that the Treasury faces an April 15 deadline to decide whether to label China a currency manipulator. That in turn would allow the US to impose retaliatory tariffs. Even normally pro-trade economists like Paul Krugman have pointed out that countries that persistently undervalue their currencies are effectively stealing jobs from their trade partners. While allowing currencies to adjust is the best remedy, taking steps like imposing tariffs to counter the Chinese export subsidy of an artificially cheap RMB is a fallback.

Our initial take was that Team Obama would stage a repeat of its stance last year: saber rattle and do nothing. But there is now bi-partisan pressure on the Obama administration to act. Not only is this move likely to be a winner domestically (and Obama is in desperate need of a win), China’s position is untenable. It has no ready way to retaliate against the US without damaging itself. Stop buying Treasuries at auction? That would drive the RMB up, exactly what they are trying to avoid. Apply tariffs to US goods? Yes, that would hurt specific US exporters, but given China’s massive trade surplus with the US, we come out net ahead on any trade war. Withhold strategic US imports, like chips? That could be disruptive short term, but would lead over time to permanent relocation of production outside China.

Ambrose Evans-Pritchard in the Telegraph contends that China is badly overestimating its power, and will come out the loser if it does not back down:

China has succumbed to hubris. It has mistaken the soft diplomacy of Barack Obama for weakness, mistaken the US credit crisis for decline, and mistaken its own mercantilist bubble for ascendancy. There are echoes of Anglo-German spats before the First World War, when Wilhelmine Berlin so badly misjudged the strategic balance of power and over-played its hand….

Clearly, Beijing is in denial about is own part in the global imbalances behind the credit crisis, specifically by running structural trade surpluses, and driving down long rates through dollar and euro bond purchases. No doubt the West has made a hash of things, but the Chinese view of events is twisted to the point of delusional.

What interests me is Beijing’s willingness to up the ante. It has vowed sanctions against any US firm that takes part in a $6.4bn weapons contract for Taiwan, a threat to ban Boeing from China and a new level of escalation in the Taiwan dispute…

We have talked ourselves into believing that China is already a hyper-power. It may become one: it is not one yet. China is ringed by states – Japan, Korea, Vietnam, India – that are American allies when push comes to shove. It faces a prickly Russia on its 4,000km border, where Chinese migrants are itching for Lebensraum across the Amur. Emerging Asia, Brazil, Egypt and Europe are all irked by China’s yuan-rigged export dumping.

Michael Pettis from Beijing University argues that China’s reserves of $2.4 trillion – arguably $3 trillion – are a sign of weakness, not strength. Only twice before in modern history has a country amassed such a stash equal to 5pc-6pc of global GDP: the US in the 1920s, and Japan in the 1980s. Each time preceeded depression.

The reserves cannot be used internally to support China’s economy. They are dead weight, beyond any level needed for macro-credibility. Indeed, they are the ultimate indictment of China’s dysfunctional strategy, which is to buy $30bn to $40bn of foreign bonds every month to hold down the yuan, refusing to let the economy adjust to trade realities. The result is over-investment in plant, flooding the world with goods at wafer-thin export margins. China’s over-capacity in steel is now greater than Europe’s output.

This is catching up with China, in any case. Professor Victor Shuh from Northerwestern University warns that the 8,000 financing vehicles used by China’s local governments to stretch credit limits have built up debts and commitments of $3.5 trillion, mostly linked to infrastructure. He says the banks may require a bail-out nearing half a trillion dollars.

As America’s creditor – owner of some $1.4bn of US Treasuries, agency bonds, and US instruments – China can exert leverage. But this is not what it seems. If the Politburo deploys its illusiory power, Washington can pull the plug on China’s export economy instantly by shutting markets. Who holds whom to ransom?

Any attempt to retaliate by triggering a US bond crisis would rebound against China, and could be stopped – in extremis – by capital controls. Roosevelt changed the rules in 1933. Such things happen. The China-US relationship is no doubt symbiotic, but a clash would not be “mutual assured destruction”, as often claimed. Washington would win.

Contrary to myth, the slide to protectionism after the 1930 Smoot-Hawley Tariff Act did not cause the Depression. Trade contracted more slowly in the 1930s than this time. The Smoot-Hawley lesson is that tariffs have asymmetrical effects. They devastate surplus countries: then America. Deficit Britain did well by retreating into Imperial Preference.

Barack Obama has never exalted free trade. This orthodoxy is, in any case, under threat in the West. His top economic adviser Larry Summers let drop in Davos that free-trade arguments no longer hold when dealing with “mercantilist” powers. Adam Smith recognized this too, despite efforts by free-trade ultras to appropriate him for their cause.

China’s transformation has been remarkable since Deng Xiaoping unleashed capitalism, but as ex-diplomat George Walden writes in China: a Wolf in the World? you cannot feel at ease with a regime that still covers up Mao’s murderous nihilism. He reminds us too that China has never forgiven the humiliations inflicted by the West when the two civilizations collided in the 19th Century, and intends to exact revenge. Handle with care.

Update 12:45 AM: Team Obama seems to be laying the ground domestically for a serious spat, given the latest PR sighting via the New York Times, “China Uses Rules on Global Trade to Its Advantage.” Looks like the American populace is being “educated” that China plays dirty. Not that I disagree, mind you, but the timing and the placement of the story (front page) is revealing.

I imagine that many readers will react as I did to the Washington Post story, “In China, Wal-Mart presses suppliers on labor, environmental standards” (hat tip reader Paul S): that this story, yet another tidbit supporting the Bentonville giant’s supposed conversion to the true green camp, has to make sense on a cold-blooded P&L basis, even if it isn’t obvious how.

Given Wal-Mart’s history in the US, it is just about impossible to imagine that the company has concern about the impact of its policies on the greater community. Wal-Mart’s low prices depend on super-low wages effectively subsidized by the public (for instance, it pays workers so poorly that they cannnot afford health insurance, so that it is a given that some will wind up getting their health care via their local emergency room, which then winds up recovering those costs from paying customers). And the company is the antithesis of a good citizen. Over 40 states filed lawsuits against Wal-Mart for failing to pay overtime when mandated by law; the Bentonville giant settled a Federal lawsuit over similar issues in 2007 and agreed to pay as much as $640 million to settle 63 wage and hours class action suits. Wal-Mart also has the largest sex discrimination lawsuit in US history pending, and has settled other suits charging discrimination.

Wal-Mart is also famous for squeezing suppliers. One attorney I worked with who had a lot of early stage companies would recommend strongly against them taking orders from Wal-Mart, for the simple reason that the retailer (if satisfied with quality) would quickly become their dominant customer, know it controlled their business, and would start pushing for lower prices and improvements on other terms.

That’s a long winded way of saying that Wal-Mart is the antithesis of an altruistic organization. In particular, Wal-Mart has a history of funding anti-environmental candidates. So why should we trust that its seemingly civic-minded action is all that it appears to be?

One interpretation is that there is indeed less here than meets the eye. Wal-Mart, according to the Post, is making impressive declarations that are not fully met in practice:

In October 2008, Wal-Mart held a conference in Beijing for a thousand of its biggest suppliers to urge them to pay attention not only to price but also to “sustainability,” which has become a touchstone for many companies.

“For those who may still be on the sidelines, I want to be direct,” Wal-Mart chief executive Lee Scott said sternly. “Meeting social and environmental standards is not optional. I firmly believe that a company that cheats on overtime and on the age of its labor, that dumps its scraps and its chemicals in our rivers, that does not pay its taxes or honor its contracts will ultimately cheat on the quality of its products. And cheating on the quality of products is the same as cheating on customers. We will not tolerate that at Wal-Mart.”…

Many critics argue that WalMart’s longtime commitment to “everyday low prices” fosters a disregard for labor and environmental standards. China Labor Watch, a New York-based organization devoted to workers’ rights in China, said in a report last Thanksgiving that “the case of Wal-Mart . . . shows that corporate codes of conduct and factory auditing alone are not enough to strengthen workers’ rights if corporations are unwilling to pay the production costs associated with such codes.”

China Labor Watch pointed to five factories where it said workers lived in overcrowded and unsanitary conditions and were forced to work excessive overtime without adequate pay. Moreover, it said, two of the five had plotted to deceive Wal-Mart auditors and had coached workers to lie during the audits.

Yves here. Wal-Mart says it is trying to do a more through job of auditing.

But there are reasons to think this push is more that a PR ploy with a few more teeth than usual (Wal-Mart is sufficiently heavily scrutinized that a mere campaign of words would not be persuasive).

First, the odds of increased protectionism are high, particularly directed against China. The US and China are engaged in a phony war, with action so far limited to tit-for-tat tariffs and some designed-to-irritate gestures, like having Obama meet the Dalai Lama. But the theater is being ratcheted up for a reason: unemployment is painfully high, and China refuses to revalue its currency. If these stresses continue (likely), politicians may feel compelled to take measures that apply more pressure to China. An obvious one, that allows the US to maintain that it remains committed to free trade, is to demand that importers meet certain minimum environmental and labor standards. Given China’s particularly poor record on environmental protection, any such effort would hit it harder than other exporters (although how one would measure adherence to this sort of standard is an open question). Wal-Mart may regard this as a real risk (as in even if the odds are only 15%, the consequences would be so disruptive that it is prudent to go down this path). This “insurance policy” approach would also be consistent with taking some steps but not going full bore until new measures looked to be imminent. But Wal-Mart did suspend 126 Chinese suppliers in 2008 and stopped dealing with 35 permanently, so some serious steps are being taken.

A second reason may be that Wal-Mart is increasingly involved in food production in China. China has industrial pollution so severe that it has cadmium and heavy metals in the soil in some areas. Wal-Mart may correctly regard establishing itself as a company that supplies food with consistent attention to environmental issues (as well as cost saving measures to prevent waste and loss) could give it an unassailable position in the Chinese market. So visible concern about environmental practices, as evidenced in its pressure on suppliers of all sorts, could be part of a long-term branding strategy (it seems odd to think of Wal-Mart aspiring to be the Costco of China, but readers have commented that its prices, ex food, seem high relative to local market levels, so Wal-Mart in China may be a more upmarket discounter than in the US).

A third possibility is that evangelical Christians are increasingly see stewardship of the earth as an important duty. If Wal-Mart does not take at least some measures that look environmentally responsible, it might risk a backlash from its core customers.

Wal-Mart seems to be less of a target of ire than it was a few years ago; its pro-environment posture and other progressive-looking measures seem to have appeased many of its critics. But I have little faith that Wal-Mart has really turned over a new leaf.

Martin Wolf, the Financial Times’ highly respected chief economics commentor, weighs in with a pretty pessimistic piece tonight. This makes for a companion to Peter Boone and Simon Johnson’s Doomsday cycle post from yesterday.

Let us cut to the chase of Wolf’s argument:

Now, after the implosion, we witness the extraordinary rescue efforts. So what happens next? We can identify two alternatives: success and failure.

By “success”, I mean reignition of the credit engine in high-income deficit countries. So private sector spending surges anew, fiscal deficits shrink and the economy appears to being going back to normal, at last. By “failure” I mean that the deleveraging continues, private spending fails to pick up with any real vigour and fiscal deficits remain far bigger, for far longer, than almost anybody now dares to imagine. This would be post-bubble Japan on a far wider scale.

Yves here. Notice he associates success and failure with polar options. But how can you “reignite the credit engine” when the financial system is undercapitalized even before allowing for the need to take further writedowns? The IMF has found the converse in its study of 124 banking crises, that purging bad debt is a painful but necessary precursor to growth. So I fail to understand how Wolf envisages that “skip Go, collect $200″ of releveraging quickly comes about. And in fact, it turns out that Wolf’s “success” is a straw man:

Unhappily, the result of what I call success would probably be a still bigger financial crisis in future, while the results of what I call failure would be that the fiscal rope would run out, even though reaching the end might take longer than worrywarts fear. Yet the big point is that either outcome ultimately leads us to a sovereign debt crisis. This, in turn, would surely result in defaults, probably via inflation. In essence, stretched balance sheets threaten mass private sector bankruptcy and a depression, or sovereign bankruptcy and inflation, or some combination of the two.

I can envisage two ways by which the world might grow out of its debt overhangs without such a collapse: a surge in private and public investment in the deficit countries or a surge in demand from the emerging countries. Under the former, higher future income would make today’s borrowing sustainable. Under the latter, the savings generated by the deleveraging private sectors of deficit countries would flow naturally into increased investment in emerging countries.

Yet exploiting such opportunities would involve radical rethinking. In countries like the UK and US, there would be high fiscal deficits over an extended period, but also a matching willingness to promote investment. Meanwhile, high-income countries would have to engage urgently with emerging countries, to discuss reforms to global finance aimed at facilitating a sustained net flow of funds from the former to the latter.

Yves here. Unfortunately, not only does it require “radical thinking” but also political consensus in a US that is badly divided, and not simply along party lines. Class warfare is in the air, and the idea of any large scale spending program will raise even more acute “But what about my share?” problems than usual.

We see a stark reminder of outcomes that will strike ordinary people, correctly, as unfair in the Wall Street Journal’s “Lending Falls at Epic Pace“:

U.S. banks posted last year their sharpest decline in lending since 1942, suggesting that the industry’s continued slide is making it harder for the economy to recover.

While top-tier banks are recovering at a faster clip, the rest of the industry is still suffering, according to a quarterly report from the Federal Deposit Insurance Corp. Banks fighting for survival, especially those plagued by losses on commercial real estate, are less willing to extend loans, siphoning credit from businesses and consumers.

Besides registering their biggest full-year decline in total loans outstanding in 67 years, U.S. banks set a number of grim milestones. According to the FDIC, the number of U.S. banks at risk of failing hit a 16-year high at 702. More than 5% of all loans were at least three months past due, the highest level recorded in the 26 years the data have been collected. And the problems are expected to last through 2010.

FDIC Chairman Sheila Bair said banks are “bumping along the bottom of the credit cycle” and that the number of bank failures in 2010 will likely eclipse the 140 recorded last year.

Yves here. There are a few problems with this picture. First, consider the throwaway “top tier banks are recovering faster” remark. Ahem, the 19 banks subjected to the stress tests hold 70% of deposits, which somewhat confounds the picture. However, it also fails to factor in the role of the implosion of the securitization market (although Freddie and Fannie have moved in a massive way as a stopgap on the housing front). So the actual contraction in credit extension, when the impact of the fall in securitization is factored in, is almost certain to make the picture even worse. And securitization, while it did include riskier corporate lending (collateralized loan obligations), the bulk of the volume was consumer and small business credit (recall that home equity and credit cards were a significant source of small business financing).

So the little guy is hit disportionately, and in cases, unfairly (I’ve heard stories of both very affluent people who used credit minimally who had credit lines cut, as well stories both in the press and recounted personally of people who were simply in the wrong zip codes, who were treated as credit risks due to the severity of area housing price declines even if they had largely or entirely paid of mortgages).

And of course, we have the elephant in the room, the seeming inability to come up with sensible mortgage modification programs (again, to a significant degree, due to the shift to securitization making it virtually impossible for the newfangled mortgage machinery to do anything on an individual basis, like assess creditworthiness, plus seemingly insurmountable intercreditor obstacles for borrowers who have second mortgages or HELOCs). The wee bit of bright light here appears to be that banks are getting more amenable to short sales.

Now the little guy versus big business distinction (where credit is more freely available) might be acceptable if there were evidence of shared sacrifice. But there is none. Wall Street bonuses are the most egregious offense, but there has been perilous little in the way of serious cuts in executive pay (John Mack’s zero bonus for three years running is a welcome and rare bit of symbolism, but even so, with the rest of the industry at the feeding trough, the austerity does not go very deep into the firm overall). And the financial press recounts on almost a daily basis the desperate efforts of banks to find new ways to fleece customersextract fees, which further stokes the resentment of an aggrieved public.

With the private sector debt overhang as great as it is, I doubt there is a way out of our mess that does not involve a period of debt restructuring and writeoffs. That process, no matter how adeptly handled, results in dislocation and has a chilling effect on bystanders (think of what it does to your mood to watch your neighbor’s house burn, even if you are unscathed. And mind you, I said neighbor, as in immediate neighbor, not the schadenfreude of seeing banksters or others seen as undeserving get their comeuppance).

Back to Wolf:

Unfortunately, nobody is seized of such a radical post-crisis agenda. Most people hope, instead, that the world will go back to being the way it was. It will not and should not. The essential ingredient of a successful exit is, instead, to use the huge surpluses of the private sector to fund higher investment, both public and private, across the world. China alone needs higher consumption.

Let us not repeat past errors. Let us not hope that a credit-fuelled consumption binge will save us. Let us invest in the future, instead.

I had a little e-mail chat with Swedish Lex, who offered his take:

The implicit conclusion of what Wolf and Johnson write is that we going forward need dirigiste economies and national and regional scale of types and magnitude that we have not seen before (or at least not in a very long time). In addition, the dirigisme would have to be closely co-ordinated globally.

I agreed with his reading of their views and noted:

I don’t see how we get close coordination. I had a talk with someone in from Hong Kong today, he is quite alarmed at China’s bullheadedness, wanting what it wants and devil take everyone else.

Plus we will not get dirigisme until the hold of the banking sector is broken. It will take a bigger bust to do that.

Swedish Lex interestingly sees another possible brake that may become operative prior to another bubble/bust cycle. He believes that the EU has much less tolerance for underwriting zombie banks than the US. The EuroBanks have written off less in the way of losses than their US peers, are also exposed to any EU sovereign debt defaults, and yet the biggest are still crucial parts of the international capital markets infrastructure (and therefore still tightly coupled to the very biggest US/UK firms). While any EU sovereign debt defaults could morph into a full blown crisis, the EU responses to the joint sovereign/bank debt overhang could lead to more radical changes in EU banking rules and practices that could blow back to the very biggest US banks in unexpected ways.

By Marshall Auerback, a fund manager and investment strategist who writes for New Deal 2.0 and Yves Smith

Conventional wisdom holds that the Chinese are due (as in overdue) for a revaluation of their currency, the renminbi. For instance, a recent report from Goldman argues that China will raise the value of the RMB against the dollar by 5% this year. The argument is that the move is needed to slow down an overheating economy.

But to a large degree, whether you agree with that as a remedy depends on what one’s reading is not just of China’s notoriously misleading statistics, but of the underlying growth dynamics, which are well out of bounds of any previous pattern, and not in a good way, either.

We question whether a revaluation is the right answer for them, and more important, whether the Chinese themselves see a revaluation as a plus. The government has engineered an enormous increase in money and credit in the past year. In fact, it seems to be as great as 5 years’ growth in credit in the previous Chinese bubble. The increase in money and credit is so great and so abrupt that you tend to get a high inflation quite quickly even if there are under utilised resources. Add to this the fact that China simultaneously is providing massive fiscal stimulus.

This combination is the making of a very messy situation. If China seeks to sustain demand via fiscal policy, the result is likely to be a big inflation problem. With many Chinese students steeped in Chicago School monetary theory coming home and assuming positions of authority, they could push for an aggressive, Paul Volcker-style effort to stop inflation.

But, what if the they don’t? Inflation can take off and thereby begin to ERODE the competitiveness of Chinese exports. Nouriel Roubini pointed out this issue in 2007: if China didn’t revalue, inflation would do the trick regardless. A continued high rate of inflation relative to its trade partners would push up the price of goods in home currency terms, which in turn translates into higher export prices. This might be the real reason why China is so reticent to revalue its currency. The Americans might go crazy if the Chinese devalued, but if the inflation is high enough, they might have to do it, as it will severely erode their terms of trade and cause their tradeables sector to collapse.

Or the hard-line monetarists triumphing by fighting inflation and the result is riots as unemployment increases.

It could get very ugly.

This could be happening now in China, although this is the opposite of prevailing views. The consensus is that inflation is a couple per cent and even that is largely due to higher pork prices thanks to a lousy corn harvest.

However, economists such as those at Lombard Street in the UK, Jim Walker, Simon Hunt and the like try to figure out the changes quarter to quarter in Chinese nominal GDP which is reported only year on year. And they come up with giant double digit growth rates for the second half of last year.

Now this is complicated by the fact that the Chinese have revised up their GDP numbers and they put all the revisions into the final quarter of the year. But when these analysts try to adjust for that statistical screw up they still come up with giant nominal GDP increases. Lombard Street thinks it was twenty five per cent or so in the second half of last year. They think it was twenty per cent real and five per cent inflation.

Economies of any size never grow at a twenty per cent real rate. And Simon Hunt says if you look at proxies like power output and rail traffic you don’t get those kinds of numbers for real growth, which suggests that inflation must be higher than four or five per cent. In general, if a real GDP figure looks sus, the first figure you examine critically is the GDP deflator.

So some evidence suggests that China’s inflation could already be at a double digit level. It is hard to say. But if it is that high, then the resultant inflation will cause a real revaluation of the trade weighted exchange rate.

And more so if the dollar rallies. That could well crush the volume of exports and the profitability of the industrial tradeables sector. Exports are the only area where China makes any kind of money because they can sell these products for about 10 times what they obtain for a comparable product in the domestic economy (where profits are virtually nil). The export sector is a big contributor to overall super excessive fixed investment in China. Dollar appreaciation means foreign direct investment will go to zero net.

There will be strong forces for a reduction in fixed investment in this large sector. Hence, there is a good chance that even without monetary tightening by the Chinese authorities, the overall fixed investment boom in China will turn down.

Nobody is thinking about this scenario but it is a real possibility. And with fixed investment now at fifty per cent of GDP (which is unprecedented in any economy) and exports at more than thirty, we’re looking at ratios that have never been reached before on a combined basis. Before readers argue that China can support that level of investment, consider the views of Professor Yu Yongding, who some analysts believe is China’s best macroeconomist. As reported in the Sydney Morning Herald:

Yu, the recently retired director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, did not explicitly say I was barking mad. But his email continued: “When a country has an investment rate over 50 per cent [of] GDP and rising, you say this country is not suffering from overcapacity! … are you serious? ”To judge whether there is overcapacity you cannot just do a head account. With a 1.3 billion population and human greed, China’s needs are unlimited, you can say that China will never suffer from overcapacity!”

The email noted that, on my logic, no developing country could ever suffer from overcapacity until it became rich and that the world should never have suffered a Great Depression in 1929.

Since that salutary critique, Yu has elaborated further on his views.

He believes China is trapped in a cycle where constantly rising growth in investment is constantly increasing China’s supply, but consumption has conspicuously failed to grow fast enough to absorb it. And so China is forced to increase investment in order to provide enough demand to absorb the previous round of increased supply, thus creating ever-widening cycles of oversupply.

In this manner, the investment share of gross domestic product has increased from a quarter of GDP in 2001 to at least half. “There is sort of a chase – demand chasing supply and then more demand is needed to chase more supply,” he says. “This is of course an unsustainable process.”

From 2005 China’s overcapacity problem had been “concealed” by ever-increasing net exports – but that strategy was interrupted by the financial crisis. Then came last year’s globally unprecedented stimulus-investment binge, which might not have been so worrying if it were delivering things that people needed. But the Government’s hand in resource allocation has grown heavier since the crisis without reforms to make officials more responsible for what they spend.

“As a result of the institutional arrangements in China, local governments have an insatiable appetite for grandiose investment projects and sub-optimal allocation of resources,” as Yu previously said, in his Richard Snape lecture for the Productivity Commission in November.

So there are now airports without towns, highways and high-speed railways running parallel, and towns where peasants are building houses for no reason other than to tear them down again because they know that will earn them more compensation when the local government inevitably appropriates their land.

Reducing investment and exports could create a severe recession in China. China has gone too far this time. They appear to be in a box that they and others don’t recognize. The “Black Swan” event this year, as far as China true believers are concerned, could well be a devaluation of the RMB. Were that to happen, the political consequences could be as significant as the economic.

Victor Shih has done some serious analytical work to try to get a handle on the magnitude of China’s local debt. His post, which included extracts from his op-ed in the Asian Wall Street Journal, shows that some of the narratives about China are woefully incomplete. The whole post is very much worth reading, but here are his main conclusions (hat tip Michael Panzner via Jim Chanos):

Did China accomplish the impossible? Did it generate almost 9% growth and maintain low debt to GDP ratio even as its export plummeted by 20%? What about claims that the torrent of investment in China has come without too much leveraging? After spending half a year looking into the debt level of local government investment entities– some 8000 of them– my conclusion is no. As in the past, the Chinese government just ordered banks to lend to investment companies set up by both central and local governments. Local governments have fully taken advantage of the green light in late 2008 and borrowed an enormous sums from banks and bond investors starting in late 2008 (well, a large amount even before that)….

So basically, in addition to the 20% of official debt-to-GDP ratio, one has to add an additional 30%. We also have to add other debt that the central government guarantees, such as the nearly 1 trillion RMB in Ministry of Railway bonds and bonds issued by the asset management companies. All of this gives China a high debt to GDP ratio. Also, there are some disturbing implications of this high debt. For one, local governments would have to sell lots and lots of land every year for many years to come to pay interest payment on this debt. Thus, to the extent that there is a real estate bubble today, it must continue for local governments to remain solvent. Regardless of what you believe about Chinese real estate, you have to think that this growth in real estate and land prices must slow or reverse at some point.

Yves here. This is consistent with what I heard at a lunch with Josh Rosner and Chris Whalen yesterday, who went on at some length about how awful the Chinese banks were, as in stuffed to the gills with bad loans. They think the idea that China is so well off by virtue of its massive FX reserves is oversold, given the black hole in its banking system.

Shih thinks the central government needs to stop leveraging by local investment companies, take over their debt, securitize it, and peddle it to local and foreign investors. Shih argues that foreign investors will take up this paper as a renminbi revaluation play.

I’m skeptical for several reasons. The act of selling this paper itself would push the RMB up. The early buyers can rely on momentum, but what about the later sales? Moreover, what will be the reporting on the performance on this debt? The US has had more than two decades to create the legal mechanisms and related reporting for securitization of debt to work (and it still wound up with considerable abuse and mispricing). Is anyone going to find the initial and ongoing reporting the underlying assets in this sort of program adequate? Highly doubtful, which means it would need a government guarantee.