China’s Economic Bubble: More Headache Ahead

When two bubbles meet what do they talk about? About Deflation.

That’s how might be captured the Chinese-US economic talks scheduled for next week. While the Chinese stimulus is giving some results, alongside with the US debt, it is giving a lot of headaches to political decision-makers, Chinese and Americans alike.

While John Mauldin has been writing an excellent piece about China’s policy in his newsletter this week-end, looking into Chinese sources only confirms the current developments.

On the one hand, the Chinese are going to hike the pressure on the US government to unwind its stimulus (probably making it virtually impossible to get into any further bailout, but also possibly killing the “pink shoots” in the egg):

China has begun laying down the groundwork for next week’s Sino-US Strategic Economic Dialogue (SED) in Washington. Vice-Premier Wang Qishan will discuss with his US counterparts how to unwind the two countries’ stimulus packages while also managing inflation. That should occur over the soup course. Also on Beijing’s agenda: urging the US to stabilize the dollar, thus protecting the value of China’s dollar assets.

At the same time China is also continuing its accumulation of raw materials (I’ll refer you to my previous post on the “art of war” to understand why):

While government types are gallivanting through Washington, one of China’s most prominent state-owned firms will be trolling for investments down under. Aluminum Corp of China (Chinalco), having had its US$19.5 billion investment in Rio Tinto scrapped, is coming back for another helping. The firm’s Chairman Xiong Weiping said that it is already discussing fresh investments in Western Australia.  Xiong made the comments one day after meeting with Colin Barnett, who heads the state government of Western Australia. Sino-Aussie relations have been strained in the past months over the failed Chinalco-Rio deal and the detention of Rio Tinto’s man in Shanghai, Stern Hu, amidst a standoff between Chinese iron ore buyers and Australian miners.  One beneficiary has been Brazil, which saw its spot iron ore vessel bookings to China rise to a record 31 in July. Bookings from Oz were down to 12 from an average of 40 in the last quarter.

Now, the aggressive expansion of China worldwide is also marked by investments into various other companies and taking participation in strategically important companies (in commodities among others, but also more “mundane investments”:

The line between the state and business got a little blurrier today with comments by Premier Wen Jiabao stating that China would use its more than US$2 trillion in forex reserves to help its companies expand and acquire overseas. While it’s long been understood that China’s big state-owned players have the backing of Beijing’s coffers, Wen’s comments marked the first official articulation of the policy, and as such are a surprise to… well, no one we guess. On the state-financed acquisition front, sovereign wealth fund China Investment Corp (CIC) has been quite busy as of late. The latest is the snatching up of a 1% stake in British beverage maker Diageo. The maker of Johnny Walker (only green label for us, thank you very much) has been making a push into the mainland market in recent years with stake purchases and partnerships with domestic wine and spirit makers. There are government funds for the greens at home too, with the recent announcement that Beijing will offer substantial (50-70%) subsidies for independent solar power projects.

Now what are the consequences to be expected from all that slush of money flowing into investments and loans? Apparently our estimate of 20 % of the Chinese stimulus flowing into the markets would be rather conservative according to some views. More important, the question is how the Chinese authorities are going to deal with this huge credit expansion as explained by Victor Shih, an assistant professor of Political Sciences at Northwestern University:

But not all the money may end up going toward infrastructure anyway. State Council researcher Wei Jianing estimates that at least 20% of the new credit has gone into the stock and real-estate markets instead of generating real benefits to the economy. This is leading to a revival of speculative investment in these markets. The Shanghai composite stock index has increased by well over 50% from the beginning of the year, while real estate prices in several major markets have climbed back near previous highs. This robust recovery took place in the face of still-declining exports and a relatively modest recovery in the growth rate. Given that result, the 20% figure may be a conservative estimate.

Should this pace of credit expansion continue for the remainder of the year, China may well face a difficult trade-off down the road. The economy is unlikely to face a financial crisis because most of the debt is owed to domestic investors and depositors and China can still prevent large-scale capital flight. However, if inflation spikes next year, the central government will have to choose between shutting off credit, which will reveal a massive nonperforming loan problem currently obscured by a torrent of new loans, or an unprecedented level of inflation. High inflation is destabilizing, as it has caused major runs on the banks before. If additional credit expansion in the face of rising inflation is not an option, the greater the extent to which lending is uncontrolled at the moment, the bigger a nonperforming loan problem the central government will face in the future.

An often overlooked ingredient to China’s success story is that generations of top-level central technocrats like Chen Yun, Yao Yilin and Zhu Rongji time and again used their political influence to constrain local investment bubbles, thus forestalling high inflation and major financial crises. Past retrenchment campaigns were unpopular and controversial, but senior technocrats nonetheless maneuvered to stop uncontrolled local investment. As credit continues to rocket toward the stratosphere, China is in increasing need of such leadership again.

And we haven’t even started considering the implications of overcapacity combined with high unemployment for the stability of the Chinese political system and its economy. On top of it all, it is stuck with huge possessions in US debt.

Now, China needs to stimulate its economy. It’s facing a very delicate situation indeed: It needs the money internally to finance its continued growth. However, if it were to sell dollar-denominated treasuries, several bad things would happen. Its currency would skyrocket — meaning the loss of its competitive low-cost-producer edge. Or, U.S. interest rates would go up dramatically — not good for its biggest customer, and therefore not good for China.

This is why China is desperately trying to figure out how to withdraw its funds from the dollar without driving it down — not an easy feat.

And the U.S. government isn’t helping: It’s printing money and issuing Treasuries at a fast clip, and needs somebody to keep buying them. If China reduces or halts its buying, the United States may be looking at high interest rates, with or without inflation. (The latter scenario is most worrying.)

All in all, this spells trouble — a big, big Chinese bubble. Identifying such bubbles is a lot easier than timing their collapse. But as we’ve recently learned, you can defy the laws of financial gravity for only so long. Put simply, mean reversion is a bitch. And the longer excesses persist, the harder the financial gravity will bring China’s economy back to Earth.

The Chinese bubble is just as unsustainable as the current US market rise. Timing the moment both bubbles burst is another question, but never forget the “black swan theory”.

Disclosure: long FXP calls.

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