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Tuesday, February 05, 2008


more on trouble in china

china is being pummeled by the worst winter in decades, and that is its own concern -- but what may be more relevant to us is that the burden has appeared at a precarious moment. via mark thoma, ken rogoff in the financial times issues a warning.

China’s remarkable resilience to both the 2001 global recession and the 1997-98 Asian financial crisis has convinced almost everyone that another year of double-digit growth is all but inevitable. In fact, the odds of a significant growth recession in China – at least one year of sub-6 per cent growth – during the next couple of years are 50:50. With Chinese inflation spiking, notable backpedalling on market reforms and falling export demand, 2008 could be particularly challenging.

True, reality has consistently flattened China forecasters who are anything less than ebullient. With 11.4 per cent growth in 2007 and the Olympics coming up this summer, why should 2008 be different? With all due respect to the extraordinary recent performance of China’s managers, the country faces economic, financial, social and political landmines just like any other emerging market, with epic environmental problems to boot. And, throughout history, no emerging market has escaped bouts of crisis indefinitely.

Inflation of more than 6 per cent is the immediate problem. Those who think inflation is caused by too little pork rather than too much money are wrong. China’s relatively pegged exchange rate system has led the authorities to flood the economy with renminbi. Rampant money supply growth is the flipside of the country’s $1,400bn accumulation of foreign currency reserves. The real surprise is that inflation did not sprout earlier.

The authorities must stuff the inflation genie back in the bottle. It is not going to be easy in an economy where highly controlled financial markets render normal instruments of monetary control relatively ineffective.

in short, china's inflationary boom may be on weak legs now. to be truthful, i suspect rogoff is mitigating when he suggests a growth recession -- china is in a full-fledged asset bubble, not inconsiderably fueled by hot western money, replete with many of the leveraging, self-reinforcing inflationary mechanisms that fuel the boom on the upside and inevitably the bust on the downside. moreover, much as was done in the united states in the great depression, china's leadership class seems inclined to react by regulating the market into obedience.

Perhaps the greatest threat to China’s expansion, however, comes from pressures created by its own exploding inequality levels. According to World Bank statistics, income inequality in China has leapfrogged that of the US and Russia, which is no small feat. Rising inequality is placing enormous strains on the political system, as is evident from a recent sequence of ill-considered policies that have been aimed at mitigating the problem. The government’s recent attempt to fight food inflation by using price controls is a highly conspicuous example.

But so, too, is the dubious new labour law which, at least on paper, prevents companies from firing workers with 10 years or more experience. It is as if China hopes to transform itself into France. Indeed, the greatest danger to China’s economy is that, after years of market-oriented reform, the country’s leadership seems to be losing faith in markets and adopting policies such as rationing that turn back the clock to old-style communist days. With rising inflation, bloated investment and a soft global economy, now is hardly the time for China to make its system more inflexible. Historically, emerging markets get into trouble when policy reform is moving backwards at the same time as an economic or financial crisis is starting to unfold.

thomas palley too noted both the fragile structure of the boom and the tenuous hold of free market principles. when the bust takes hold, it could be a very bad one. we think we have a moral hazard problem fueling speculation in the united states and we very probably do -- but it is nothing compared to china's stock market, says michael pettis from beijing.

Although I am a little surprised at the extent of my gains, I am not at all surprised that my shares, and the market more generally, is up significantly today.

In fact I knew all weekend that my shares would be up today. How did I know? Easy. Everybody knew the market would be up today because the government very cleared signaled over the weekend that it wanted the market to go up. It was as simple as that. ...

About four months ago, as a sign that it was very unhappy with the excess rise in the stock market and wanted it to come down, the government embarked on a series of measures to bring prices down. One of these measures was to prevent the launch of new mutual funds – always an important sign here of the government’s intentions. The market duly collapsed. ... But now, ... the government made it clear that it believed the decline in the markets of the last three months has been excessive and may begin to have adverse effects on public sentiment. It was time for the market to go up.

A purely speculative market does not allocate capital efficiently based on reasonable estimates of future earnings prospects. Speculative investors simply try to exploit short-term price changes, usually based on changes in short-term demand or supply factors. In China the only important piece of information is about short-term changes in government and regulatory actions caused by changes in the government’s current intentions (and these change dramatically month-by-month and even day-by-day sometimes). Bloomberg quotes a grateful fund manager today as saying: “It is encouraging to investors that the government has done something to intervene in the market decline. We are probably already at a level where the regulators don't want to see a further decline.” Recent activity simply reinforces the message that in the Chinese markets the only thing that matters is the government’s intention, and the only people allowed to play are the speculators.

this reminds me of nothing so much as the statements issued by members of the coolidge and hoover administrations, which had the invariable effect of sending the market soaring or diving, all the way into the crash of 1929.

but the ultimate truth is that the chinese government does not control the outcome -- such is an illusion that many people are participating in, much the same as people believed in the american government's power to fuel the boom in the 1920s or believe in the federal reserve's power to do the same today. the participants in every asset bubble of history have ascribed miraculous powers of continuation to some authority or another in order to assuage fears stemming from the obvious but unadmitted absurdity and fragility of it all. it's a pleasant lie but a lie nonetheless.

the outcome is controlled by the leverage involved -- and it by now must be massive.

pettis also notes that economic numbers coming in from before the storms were not good, indicating that the asset bubble had gotten beyond the control of the government and that the government was now taking radical steps to haul it in.

Make no mistake – we are still in the cocaine-fueled stage of crazy growth and the question is mainly whether there’s enough cocaine, in the form of monetary expansion, left to keep this party going.

Fixed asset investment grew by 24.8% for the year, to RMB 13.7 trillion, roughly equal to 56% of 2007 GDP and slightly higher than the growth in 2006 (23.9%), with investment in the booming (and overheated) real estate sector up 30.2% in 2007, compared to 21.8% in 2006. This real-estate surge does not bode well for the banking sector because a big slice of their loans (and, I suspect a bigger slice of their future non-performing loans) are real-estate-related. There has been a sharp improvement here in the sense that December’s increase in FAI, 19.3%, was much lower than November’s 26.1% and October’s 30.6%. These numbers I got from Credit Suisse, who reads this decline as very positive and indicative of a soft landing. I still see these numbers as too high, and given the lag between investment and production, indicative of trouble ahead if we do see a slowdown in global demand.

What about a US slowdown – will that help moderate Chinese growth? I am not able to handicap the probability, severity, or duration of a slowdown in the US economy, but I have never put much faith in the decoupling story and I suspect that a US slowdown will bring Chinese export growth down, perhaps even sharply.

Its impact on the underlying economy, however, will come with a dangerous lag. This is because a decline in exports will not immediately impact the trade surplus enough – a concomitant drop in consumption and in imported products for re-exports will mean that the trade surplus will remain extremely high, even if it declines substantially from the string of record monthly surpluses in 2007. When the capital inflow consequence of this high trade surplus is added to hot money inflows, Chinese monetary growth will remain extremely high, and with it fixed asset investment and industrial production growth. Chinese producers may find themselves caught in the vise of rising production and declining demand.

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