Wednesday, 10 March 2010 23:00

What Are the Odds That China Will Follow 1920's US and 1980's Japan?

Today in the news: China Inflation, Production Accelerate, Adding Pressure for Stimulus Exit

March 11 (Bloomberg) -- China’s inflation reached a 16- month high, industrial output climbed and new loans exceeded forecasts, adding to the case for the government to pare back stimulus measures.

Consumer prices rose 2.7 percent in February from a year earlier, the National Bureau of Statistics said in Beijing today, compared with the 2.5 percent median estimate of 29 economists surveyed by Bloomberg News. Seasonal factors stemming from a weeklong holiday may have boosted prices. Production rose 20.7 percent in the first two months of 2010, the most in more than five years.

Contrary to many, not only do I believe China is in the throws of a credit driven asset bubble, but its touted safeguards point the way to drastic correction.

China huge foreign reserves: Not a savior for the country if the asset bubble bursts

The concerns highlighted by Michael Pettis (a professor at Peking University's Guanghua School of Management, "Never short a country with $2 trillion in reserves?") are telling, particularly that huge foreign exchange reserves are not a sure shot solution for preventing China from a future financial crisis. I would like to amplify the message contained therein, since the news coming out of China reinforces the fact that it is really not "different this time" so emphatically.

The Author states:

"...Let us leave aside that the PBoC's reported reserves are a lot more than $2 trillion, and that if correctly accounted they would be pretty close to $3 trillion. China's foreign reserves are certainly huge. They add up to an amount equal to about 5-6 % of global gross domestic product.


But they are not unprecedented. Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.


The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as "all the bullion in the world". At the time, total reserves accumulated by the US were more than 5-6% of global GDP...


The second time occurred in the late 1980s, when it was Japan's turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5-6% of global GDP. By the late 1980s, Japan's accumulation of reserves drew the sort of same breathless description - much of it incorrect, of course - that China's does today.


Needless to say, and in sharp rebuttal to Friedman, both previous cases turned out badly for long investors and brilliantly for anyone dumb enough to have gone short. During the early years of the Great Depression of the 1930s, US stock markets lost more than 80 per cent of their value, real estate prices collapsed, and the US economy contracted in real terms by an astonishing 30-40 per cent before recovering in the 1940s.


Japan's subsequent experience was economically less violent in the short term, but even costlier over the long term. During the period following its astonishing accumulation of central bank reserves, its stock market also lost more than 80 per cent of its value, real estate prices collapsed, and economic growth was virtually non-existent for two decades.

Reserves of course are not useless as an enhancer of financial stability, but their use is for very specific forms of instability. Having large amounts of reserves relative to external claims protects countries from external debt crises and from currency crises."

The key term here is "external". China does not face an external debt concerns, as the country's foreign claim as per BIS (Bank for International Settlement) stood at only $278.6 billion at the end of September 2009 (which is only 5.3% of the country's 2010 expected GDP as per IMF). However, China's domestic debt currently remains at an uncomforting level (as we will see in our discussion below)

"The risks that China faces today (and the US in the late 1920s and Japan in the late 1980s) is of excessive domestic liquidity having fueled asset and capacity bubbles, the latter requiring the uninterrupted ability of foreign countries to absorb via large and growing trade deficits. These risks include an explosion in domestic government debt directly and contingently through the banking system... "

This risk is visible in the recent finance ministry announcement to nullify all guarantees local governments for loans taken by their financing vehicles, and its plan to issue rules banning all future guarantees by local governments.

If local government debt that China's local governments have been raising through off-balance sheet (and similar) investment vehicles to circumvent direct borrowing regulations - and which is not counted in official calculations, is included in the total debt - then the country's debt could rise to 39.838 trillion Yuan or $5.8 trillion. This puts China in similar debt standing with many of the PIIGS, being that its accounting for 96% of GDP, much higher in comparison to the IMF's estimate of 22% which excludes local-government liabilities, in 2010 based upon research by Northwestern University's Professor Victor Shih, who estimates China's local- government outstanding debt at the end of 2009 at 11.429 trillion Yuan.

This puts China 4th in line, behind Italy, Belgium and Greece in terms of gross debt to GDP!

"... And reserves are almost totally useless in protecting these economies from the risks they face (and, no, no, no, reserves cannot be used to recapitalize the banks - only domestic government borrowing or direct or hidden taxes on the household sector can be used to recapitalize the banks). In fact, it was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity (sound familiar?). These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit."

The above case is most accurate in regards to China, where the accumulated reserves have come from preventing Yuan appreciation, rapid urbanization and rising worker productivity (which remains one of the key drivers for the country's exports). Thus, if we go by historical precedence, a huge financial reserve for China does not safeguard the country against a financial crisis.

These similar concerns are being supported by other analysts and economists. Trend forecaster Gerald Celente believes that the depression is global and a contraction across the entire planet cannot be avoided, and that includes China.

Economist Harry Dent holds a similar view, recently saying that, "China will see their bubble collapse strongly when the U.S.-led stimulus program fails due to rising defaults and foreclosures later in 2010, at the same time that the world is looking for China to pull it out of this global downturn."

As suggested above by Michael Pettis, though foreign reserves can be used for very specific forms of instability, there is one way in which China can use its reserves to tackle the current problem of rising domestic debt, that is by converting its foreign currency denominated assets (which is primarily dollar for China) to Yuan.

However, this would lead to appreciation of Yuan against the USD. With China being an export-driven economy, this is a measure of very last resort.

But eventually, China will have to appreciate Yuan as it is facing considerable international pressure from its trading partners, more importantly, it looks like the only way to ease strains on the country's fast growing economy. We feel that this will not be a voluntary move (China faces new pressure to let currency rise).

Subscribers should reference the following related topics/documents:

Last modified on Wednesday, 10 March 2010 23:00

7 comments

  • Comment Link Amiel Sac Wednesday, 20 April 2011 08:07 posted by Amiel Sac

    "I think quite a while ago I read that even local governments can print CNY"--rogerjarema

    Really? This is indeed alarming! How do they put value to their money then? Don't they have a central bank or something?

    Amiel "the marriage therapist"

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  • Comment Link Reggie Middleton Thursday, 11 March 2010 14:35 posted by Reggie Middleton

    Re: China - point taken. Inflationary pressures are behind the theory of the currency rise. It boils down to inflation vs deflation, with a very thin line in the middle that will result in anything other than a disaster. A very unlikely line for a government to be able to walk.

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  • Comment Link shaunsnoll Thursday, 11 March 2010 13:31 posted by shaunsnoll

    S&P – Yesterday was our 9th consecutive positive close, only the 3rd time in the last 10 years. There has not been a string of 10+ days in the last 10 yrs and there have never been 11+ consecutive days….

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  • Comment Link rogerjarema Thursday, 11 March 2010 12:51 posted by rogerjarema

    Reggie, I agree with the enormous bubble in China waiting to burst & that it will bring very severe global recession (if you don't want to call it "depression"). However, one point I still have trouble agreeing is that CNY will rise against USD.

    China's money printing is way crazier than the US. I think quite a while ago I read that even local governments can print CNY. And... other troubles existent in the economy you have mentioned & summarized it very nicely. Given these conditions, along w/ the public's total one-sided opinion: CNY will rise if it is floated, I have serious troubles believing it will rise against USD. The problems are too enormous & God knows... when the bubbles collapse, perhaps the Communist Party will have to fight for their very existence. Usually things like these (social unrest, political instability) are not supportive to the currency, either.

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  • Comment Link shaunsnoll Thursday, 11 March 2010 12:18 posted by shaunsnoll

    http://www.iimagazine.com/Popups/PrintArticle.aspx?ArticleID=2286521

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  • Comment Link shaunsnoll Thursday, 11 March 2010 11:05 posted by shaunsnoll

    if you look at some factors in the chinese ppi numbers they are seeing 8% inflation in some areas. they can't keep the liquidity spigot open for too long if inflation starts running up past 10%.....

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  • Comment Link Reggie Middleton Thursday, 11 March 2010 08:46 posted by Reggie Middleton

    [quote]Sam told me flat out that "even if there is a bubble, they will deal with it quickly. China saw what happened to Japan, and they don't want to end up like them."[/quote]
    Well, the Japanese saw what happened to the US in the 1920's, did that stop them? The US saw what happened to Japan in the 1980's, did that stop us? Please don't tell me that "This time is different", or worse yet the Chinese are smarter than the Americans and the Japanese. Booms and busts are a function of human, and by extension political nature. I don't think it is structurally possible for China to avoid a bubble, because they are already there. Look at the unused capacity in existence (as a net export nation), that is currently being added to as much of the world slides back towards recession.
    [quote]
    I will repeat what I've said before: short Chanos on China. He and others warning us of an impending Chinese implosion have no clue of what they're talking about.[/quote]
    As you may have been able to tell, I am primarily a data driven sort of guy. I don't make any decisions based on what Chanos, et. al. have to say. I actually came to very similar conclusions, totally independently. My analysts don't get paid per transaction, hence they are totally independent as well. We shall see what comes of it, but practically all of the signs of a credit derived bubble are there. If it looks like a duck, quacks like duck and walks like a duck, is it a Swan?

    Check out this quacking swan from the news lines posted on ZH front page:


    Asian bourses turn lower after release of higher-than-expected Chinese inflation data. - Inflated prices: Quack!
    Bank of Korea keeps key interest rate at record low as economic growth slows. Chinese importer and trade partner slows, makes China hesitant to pull stimulus that is obviously being directed towards inefficient ends, ex. real estate speculation: Quack!
    China inflation, production accelerate, adding pressure for stimulus exit. - Inflated prices, particular housing: Quack!
    Chinese property prices were 10.7% higher than a year earlier in February: Govt agency. - Quack x 1.107 times extrapolated over 12 months. One hell of a loud quack, maybe a full double QUACK!
    Japan's Q4 GDP grew at an annual 3.8% pace - lower than the prelim reports of 4.6%.: Major Chinese trade partner slows, making China hesitant to pull stimulus although prop prices are flying at least twice as fast as incomes, quack!

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