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