Monday, May 3, 2010

The Possibility of a Chinese Propety Bubble and its Monetary Challenges

I have previously reported on the Chinese money-supply, but have not done so lately because the Peoples Bank of China has not reported money-supply information since January in their Chinese-language statistics page, and have not reported any statistics for 2010 in their English-language statistics page. This makes it exceptionally frustrating to hear about asset-price bubbles happening in the Chinese property market. Part of me really wants to believe the hype, because the increasing reserve requirements indicate monetary tightening and an attempt from the PBoC to cool down lending, but I would like some hard evidence.

As long as there is strong demand for funds by households or businesses, monetary tightening will raise interest rates, which should be able to cool down speculative activity. The problem here is that a globalized financial system means that rate increases could very well lead to large capital inflows as American, European and Japanese investors reach for yield since their respective central banks are keeping interest rates depressed. Compounding this problem is all the talk there has been about Yuan appreciation.

The reason that using rising rates to slow-down excessive speculation combined with expectations of a stronger Yuan is dangerous is that if low-interest rate country investors move money to China chasing yield, it will create added demand for the Yuan and excess supply for the home currency. In large enough quantities, this same pressure could put additional upward pressure on the Yuan compared to the Yen/Dollar/Euro. If the Chinese authorities crack to US pressure and allow appreciation of the Yuan, then this move up would only reinforce this behavior, creating a self-feedback loop, or, as it is otherwise known, a self-fulfilling prophecy. This is not an academic scenario, carry traders have systematically depressed the Yen and strengthened their target currencies for years with New Zealand being a prime example. If you are interested in the subject I highly recommend the last 3 chapters of The Holy Grail of Macroeconomics, Revised Edition: Lessons from Japans Great Recession.

Additionally, rising rates in China coupled with a strengthening currency would only serve to fuel an asset-price bubble, as money pouring into China seeks an asset to be parked in. If it's not foreign money, it could very well be local businesses borrowing abroad. I am not familiar with the specifics of the Chinese monetary policy, but depending on the amount of restriction there is with regards to borrowing abroad, it would be attractive for businesses to borrow at depressed rates in Japan or the US and use it to buy property in China. In addition to paying a lower interest-rate, Yuan appreciation would mean that dollar debts would be reduced in Yuan terms, driving the already low borrowing costs even lower, reducing the cost of carry and driving ever more speculative investment. This could continue until the PBoC either succeeds in cooling down a booming property market or the whole thing collapses onto itself. While the first option could create a small garden-variety recession, the second option would create huge losses to the people of China, create a violent swing in the exchange rate and push china into a balance-sheet recession.

If the MSM writings on China are correct and businesses are making speculative property investments with borrowed money, this has the potential to be a giant balance sheet recession in the making; however, if the purchases are not significantly leveraged, losses are likely to be absorbed by owner equity instead of a US-style housing bust where NPLs quickly spread to banking system and lead to a credit crunch and full-on systemic crisis.

Until I can find official numbers on the amount of real-estate financed with debt, I won't know if there really is a Chinese real-estate bubble or the magnitude of it. Until then, though, I will keep watching both the moves of the PBoC and Yuan for clues as to the presence of a bubble. A refusal of the Chinese authorities to allow Yuan appreciation wouldn't necessarily be a case of "mercantilist" policies or export subsidy as much as it could be the Chinese trying to prevent further asset-price increases resulting from capital inflows.

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