China, bubbles, trade wars and balance of payments

Let's start with the alleged "property bubble," I still have doubts about that big crash coming, increases in property prices have been high, but accounts of high inflation would mean that catastrophic nominal price declines are doubtful. Property prices may lower or stagnate in real terms, but a high rate of inflation--which has its own, different problems--would keep nominal paper profits intact, reducing the risk of widespread loan defaults and huge banking losses that would lead to US-style crash and subsequent balance-sheet recession. Double digit inflation has its problems, but Latin American and other emerging economies have been doing it for many, many years, and they're OK--it's not catastrophic.

Putting aside events that have not happened yet, it's important to look at a bigger picture. As Pettis so eloquently put it last week:

5. If Europe’s current account surplus grows, there must be one or both of two automatic consequences.  Either the current account surplus of surplus countries like China and Japan must contract by the same amount, or the current account deficits of deficit countries like the US must grow by that amount, or some combination of the two.
6. If the Chinas and Japans of the world lower interest rates, slow credit contraction, and otherwise try to maintain their exports – let alone try to grow them – most of the adjustment burden will be shifted onto countries that do not intervene in trade directly.  The most obvious are current account deficit countries like the US.

What we are seeing here is a tough problem for China. On one side it needs to tighten to get a hold on on inflation and prevent potential asset-price bubbles but, on the other hand, doing so would transfer more of the global adjustment burden to itself, losing exports and hurting local businesses. If China decides to keep interest rates low to defend its exporters, potentially negative real interest rates would inevitably create mal-investment and fuel potential bubbles. If it doesn't, then it would risk a recession and widespread pain to its exporters as the result of drastic drops in imports by trade deficit countries as they try to curtail said deficits or even become net exporters. The money-supply data posted earlier is indicative that Chinese "tightening" still leaves pretty loose monetary policy. It really looks like China is in a real bind as a result of its unsustainable attempt to grow at the cost of other nations.

Pettis argues that because China has seen de facto revaluation as a result of the EURUSD drop, China could buy Euros, lots and lots of them, strengthening the Euro vs the Yuan. The problem I see, and Pettis describes, is that trade deficit countries are trying to lower their deficits or even become exporters, but too many people are trying to do the same thing at once, and China, the country with the largest trade surplus, doesn't want to give part of it up. The scary thing I see here is that depressing one's own currency is being seen as the key to exports and therefore prosperity, but if everyone is playing that game, what we'll be left with is a fiat-currency race to the bottom--something I hope never to see in my lifetime, as I don't like guns or canned food.

In my opinion, what China could to do is develop a larger domestic demand for its products. Playing a little game of this thing that looks like that thing, the current practice of exporting stuff and importing money seems a tad Mercantilist, in my opinion. Maybe instead of exporting stuff and importing money (debt, actually) they could import and export stuff. Or keep more of their goods at home, allowing for a larger accumulation of goods by the Chinese people--after all, value creation is not a zero-sum game. Moreover, I firmly believe that the people of China would be better served by working on their country instead of building us trinkets. By that, I mean that the marginal utility of undertakings like education (child and adult alike), immunization, water-treatment, waste disposal, infrastructure improvements and investments in whatever increases quality of life is higher than that of factory work making trinkets for sale in the US. Sometimes I really wonder if policymakers understand that the best and most sustainable path to increasing your wealth is not to take someone else's, it's to create your own.

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.