Andy Xie: Getting The Yuan Right

Everyone is now talking about Yuan's appreciation. Now back in April, Andy Xie wrote the following piece, Get the Yuan Right, Prove Pundits Wrong and Andy actually thinks the opposite. He reckons that the Yuan appreciation is a bubble!!

• Hype over an 'imminent' increase in yuan value ignores China's greater need for higher interest rates and fewer bubbles
  
  Unless China exits its economic stimulus quickly, the nation's inflation rate could rise to double digit levels sooner than many expect. The right sequence of events for a proper response to inflation would be to raise interest rates and then, if necessary, move the yuan exchange rate.
  
  But acting on the currency first, especially in small steps, would further inflate China's property bubble and inflation, potentially leading to a major economic crisis in two years. A small increase in the yuan's value would fail to resolve two pressing problems: inflationary pressure at home, and political pressure from the United States. Moreover, a small appreciation would attract hot money, stoking inflationary pressure.
  
  Imported goods' share of consumption is too small in China for a small currency appreciation to affect the consumer price index. At the same time, a minor appreciation would fail to placate U.S. interest groups, some of whom are demanding a rise in yuan value of one-third or more. Some argue it should double in value. Indeed, a slight appreciation would merely exacerbate existing problems by emboldening U.S. supporters of a stronger yuan to demand even greater appreciation.
  
  Meanwhile, financial markets are back on the yuan appreciation watch. Inflation pressure at home and political pressure from the United States have inflamed expectations. Every week or two, the media reports that some notable person has predicted an imminent yuan appreciation of 5 percent or so. So much ink has been spilled on this issue that the consensus on yuan appreciation has become the longest lasting and most widely accepted consensus in financial history. It's lasted for so long because financial markets have few stories to stir fry, and an appreciation of a pegged currency is a free lunch. Nothing gets financial markets more excited than a free lunch.
  
  The intensity and persistence of yuan appreciation expectations point to support for China's vast property bubble. These expectations have increased the concentration of hot money in China, which in turn has caused excess liquidity and speculation, fueling the property bubble.
  
  By all measures (stock value to GDP ratios, inventory value to GDP ratios, new property sales to GDP ratios, price to income ratios, rental yields, and vacancy rates) China's property market is one of the biggest bubbles ever. It's probably much bigger than the U.S. property bubble relative to GDP.
  
  Now, the same liquidity that fueled the property bubble is leading to rapid pickup for consumer price inflation. One just needs to look around to see the seriousness of the inflation picture, regardless of how it's measured. Denying that inflation is serious in China right now is akin to burying one's head in the sand. This sort of denial is how countries in Southeast Asia got into a crisis situation in the past: They kept real interest rates too low and fueled speculation that eventually destroyed their banking systems.
  
  If China's economic stimulus is withdrawn, the property bubble will cool. And it may even burst. This is why so many interest groups consistently argue against higher interest rates. Instead, they support using currency appreciation to cool inflation.
  
  Why is this policy option so popular among interest groups? Because it would fuel the hot money inflow, which in turn would support and expand the property bubble. Of course, inflating the property bubble will only worsen inflation. And the odds are that a small currency appreciation would only make the property bubble bigger and inflation worse.
  
  In a standard economy, currency appreciation cools inflation by decreasing import prices. China's imports are mainly raw materials, equipment and components. A small currency appreciation would have virtually no effect toward cooling inflation. So while a small appreciation might be justified politically, it should not be used to fight inflation.
  
  On the other hand, a major appreciation or revaluation could cool inflation by removing further currency appreciation expectations. It would trigger a hot money exit from China, creating a liquidity crunch that would almost certainly burst the property bubble. I doubt anyone would support such a policy move.
  
  For China to achieve a soft landing from the current property bubble – if this is at all possible – interest rates must steadily increase by 2 percentage points in 2010, another 3 points in 2011, and further in 2012. Such a trajectory for interest rates would not burst the bubble, but it would prevent real estate interest rates from further declining in an atmosphere of rising inflation. At some point, real estate interest rates will start inching up and slowly rein in speculation. Stopping real estate interest rates from declining further would prevent inflation expectations from accelerating, which in turn could halt inflation's accelerating pace.
  
  Getting It Wrong
  
  But let's return to fact that the most widely held belief today on Wall Street is that a rise in the yuan's value is a foregone conclusion. In the past, Wall Street forecasters have had trouble getting big calls right. Indeed, over the past two decades Wall Streeters have missed three of the biggest calls: the East Asian Miracle, the Internet Revolution, and Financial Innovation, i.e., derivatives. All three mega-trends had considerable substance. But U.S. financial markets misread implications of these trends.
  
  In 1995, the most widely accepted consensus on Wall Street was that Southeast Asian currencies such as the Malaysian ringit would surely appreciate. At the time the East Asian Miracle – referring to strong, prolonged economic growth for Southeast Asian economies and South Korea – was all the rage on Wall Street. It was rooted in the fact that these economies had been growing with strength for many years.
  
  But it was wrong to conclude that their currencies should appreciate. Many well-known hedge funds took big positions on these currencies in 1995, but two years later the Asian Financial Crisis brought them down. Currencies that had been under appreciation pressure two years earlier suddenly collapsed.
  
  Wall Street got the causality of currency strength and economic growth all wrong. The East Asian Miracle was based on cheap currencies that supported export growth. Inflation ended the model, as inflation makes a currency more expensive. An export economy can avoid inflation with a big appreciation of its currency as soon as inflation hints surface. But when inflation persists for a number of years, a currency has already appreciated sufficiently in real value, and the right policy response is to increase interest rates substantially to cool inflation. In 1995, currencies of the East Asian Miracle economies were already overvalued after many years of high inflation. The Wall Street consensus then created speculative demand for these currencies and, hence, appreciation pressure. In other words, the appreciation pressure was a bubble.
  
  In 2000, the Internet explosion seized Wall Street's imagination. It was a revolutionary technology that promised to raise economic productivity substantially – and it did. But investors who enthusiastically bought Internet stocks lost billions.
  
  Too many analysts hyped Internet companies on the premise that companies would reap all the revolution's benefits. Although these companies were indeed driving the revolution, competition passed most of the benefits to consumers in terms of lower prices. Profits were sketchy.
  
  More recently, financial innovation in the form of derivatives and synthetic financial products promised to decrease risks and, hence, lower funding costs for all. The belief in their effectiveness led to rising demand and, hence, leverage. Subsequently, rising leverage led to a credit bubble. For a few years, the credit bubble kept the economy strong, controlling bankruptcy rates. A visible, declining risk strengthened the belief that derivative products were indeed decreasing risk, which further inflated demand for them. Now we now it was a bubble.
  
  Right on the Yuan?
  
  If Wall Street got its biggest calls wrong over the past two decades, might it be wrong on the yuan, too? On the surface, it seems self-evident that the yuan is under appreciation pressure. Like any product, a currency's value depends on supply and demand. When the two are mismatched, foreign exchange reserves rise or fall. China's foreign exchange reserves have risen massively in the past five years, which means demand for the yuan has exceeded supply. This could be viewed as prima facie evidence that the currency is undervalued.
  
  Some argue that pressure for a rising yuan is not a bubble by noting that China's large trade surplus contributes to about half of the increase in foreign exchange reserves. Hot money may be responsible for only half the pressure. Hence, they say, it cannot be a bubble. But history is full of examples of currency appreciation pressure building a bubble.
  
  I am surprised that China is still running a trade surplus. The surplus is declining, but considering how depressed the world economy is and how hot China's is, a trade deficit would be more likely. The surplus, I think, can be attributed more to distortions in domestic pricing than the currency's cheapness.
  
  First, high property prices are a major deterrent to middle class consumption. In mature economies, rising property prices boost consumption through a positive wealth effect because most middle class households already own property. In China, the positive wealth effect is limited because the credit system is not there for the middle class to monetize capital gains. But first-time buyers, such as newlyweds, have to save more to purchase property. Indeed, since prices are so high, parents have to save to help them. Hence, China's property bubble suppresses consumption and, therefore, boosts the trade surplus.
  
  Second, prices for middle class goods and services are very high. Autos stand out: Prices in China for cars, even those built domestically, are the highest in the world. Auto demand has been rising rapidly with middle class expansion, but it would rise even faster without price distortions. Imports would be much higher, too, which would reduce the trade surplus. Actually, though, consumption in China is higher that should be expected, since China's middle class incomes are only 20 to 30 percent of OECD levels.
  
  Third, China's taxes on the middle class are too high. The top marginal income tax rate of 45 percent applies at quite low income levels by international standards. The 17 percent VAT is also among the highest in the world. Because China tends to invest its tax proceeds, high taxes suppress consumption.
  
  If China's property and consumption prices as well as tax rates decline to international levels, would China still have a trade surplus? Good question. If the answer is yes, the right policy would be to adjust prices rather than the exchange rate.
  
  Whenever a country successfully industrializes, its currency value should appreciate. This appreciation can come in the form of a higher exchange rate or inflation. What worries me is that inflation has already happened. China's real exchange rate may have appreciated greatly in the past three years. Even though China's reported inflation rate has been relatively low, prices that one encounters in daily life appear to have risen enormously. Foreigners who visit China are often surprised by prices, which are even higher than in many developed countries. Even China-made retail products are more expensive in China than in other countries.
  
  I am not sure that yuan appreciation pressure is entirely a bubble. But a big chunk is. Instead of looking at appreciation pressure per se, it would be better to get rid of the hot money and clean up domestic price distortions. These should be the first steps. If yuan demand still exceeds supply afterward, the exchange rate should move.
  
  Many analysts argue that raising interest rates would attract more hot money. This is wrong. Hot money comes to China for currency appreciation and asset bubble reasons, not to chase interest rates. When an interest rate is raised, expectations for property price appreciation wane and hot money is more likely to fall than rise.
  
  Increasing the yuan's value a bit would certainly trigger more frenzy. Any new property booms that follow may support the economy for a time. But the long term consequences would be severe. Indeed, a small appreciation could make a crisis inevitable.
  
  The temptation for a small move in the exchange rate is high. It seems to be a cost-free step. Many hope the United States would be placated by it. Even though exporters may be hurt a bit, the near-term domestic economy could benefit. It may seem a perfect short-term fix. But it's the wrong thing to do, because there is no real free lunch. What's free one day could cost a lot more in the future.
  

Impact Of The Foxccon Suicides On China Labour Market?

Ever wonder the impact of the Foxconn suicides on the China labour market?

Foxconn raised its workers pay by about 30%.

How would this impact the Chinese labour market? Would this signal the end of the cheap labour market?

Well Andy Xie has written one very interesting piece on this issue.

• By Andy Xie 06.07.2010 11:17
  Dismantling Factories in a Dreamweaver Nation
  
  A new generation is challenging China's labor-squeezing business model and an older generation that apparently doesn't get it
  
  A decade ago, I took a group of fund managers to an assembly line at an electronics manufacturing contractor in China. We saw rows and rows of young women hunkered down, concentrating on putting together tiny parts. They had few toilet breaks, and during rest periods they had to sit at their benches.
  
  "They're all 18," the line manager told me. "We need nimble fingers. In a few years, we will replace them with another batch of 18-year-olds."
  
  I wrote a story after that visit. I didn't judge the situation but stated that a compliant labor force willing to be pushed to the extreme was the fuel for China's economic miracle. The engine was the mutually beneficial relationship between western companies with technologies, brands and distribution channels, and China-based manufacturing outsourcing companies that specialized in taking advantage of China's vast, cheap labor force. These included Taiwanese companies, which have been by far the most successful in the original equipment manufacturer (OEM) business.
  
  The fund managers with me on the visit wanted to determine sustainability and profitability before deciding whether to buy the company's shares. They thought an endless supply of labor would ensure the model's profitability, and they were bullish about the company. What's happened in the years since has proven them right.
  
  But will they be right indefinitely? To answer that question, we can glance back to the days of silent film star Charlie Chaplin. In his movies, Chaplin parodied the inhumane nature of the modern factory system, especially monotonous human movement on assembly lines. What he portrayed vanished a long time ago in developed countries, driven out by rising labor costs. Factory owners invested in automation, such as robots that now dominate modern auto assembly plants.
  
  When multinational companies outsourced production to China, though, their business became less capital intensive. They took advantage of low labor costs and abundant supply. Some businesses, such as battery makers, started substituting machines with people. But no one could have predicted how far the outsourcing model, particularly in the electronics sector, would go while companies scaled up and maximized economies of scale by using cheap labor.
  
  Scaling Higher
  
  Economies of scale are typically associated with capital intensive industries. When a business requires a lump-sum fixed investment, it requires a certain scale to make the investment pay. Outsourcing businesses in China are labor intensive but have scaled up massively. Some businesses employ hundreds of thousands, often at a single location. So where do they get the economies of scale?
  
  I know of two factors that can be scaled up in such businesses: customer relations, and what I call labor squeeze.
  
  Good relations with big buyers such as Apple and HP are not easily obtained. Years of interaction are needed to build necessary trust. Suppliers that prove better than others are retained, while the rest are dumped. As time goes by, the number of suppliers shrinks and the survivors expand.
  
  Thus, economies of scale are improved through good management of customer relations. Apple, for example, demands total secrecy in the production of its products. This goal cannot be met if it uses many suppliers, so when it signs with a trustworthy supplier a virtuous cycle is created.
  
  An even more important factor is labor management. What I observed during my visit 10 years ago was actually the key to economies of scale. To put it bluntly, the key competence of a successful OEM in China is to squeeze labor to the maximum extent possible. That skill is developed within an organization. When a company employs hundreds of thousands from all over China, it needs a massive machine that involves recruiting, housing, training, and worker management on the factory floor.
  
  For example, the factory I visited derives its economies of scale from 1) knowing where to find all the 18-year-old girls, 2) convincing them to stay in factory dormitories, 3) training them to put the parts together, and 4) ensuring that no one takes too many toilet breaks. This is all part of a huge system that can derive considerable economies of scale by processing hundreds of thousands of workers.
  
  Labor management as a core competitive advantage in East Asia began in Japan. After the Meiji Reforms, Japan wanted to industrialize quickly but faced the challenge of turning agricultural labor into industrial labor. It looked to the military for a role model. The military faced a similar challenge: It had to turn farm boys into soldiers. The answer was maximum pressure and total regimentation. Factory uniforms, morning exercises, company loyalty indoctrination, etc., thus became unique characteristics of Japanese factories.
  
  This model becomes less relevant as the transition from rural to urban labor force winds down and labor costs rise. Nowadays, Japanese factories have few workers and lots of robots on factory floors.
  
  The Japanese military factory management system spread to other parts of East Asia, especially Taiwan. It was a Japanese colony for a half-century and receptive to Japanese management skills. When the yen's value rose in the 1970s, Taiwan got its first opportunity to take away Japanese market share by adopting the Japanese factory management system.
  
  And when the Taiwanese took their businesses to the mainland, they found a place for applying their skill with 50 times as many people. Because they combine the Japanese system and knowledge of China's labor force, they are better than Japanese in managing factories in China.
  
  The magnitude of scaling up by Taiwanese businesses is beyond what the Japanese could have imagined. Indeed, no other businesses have done what Taiwanese businessmen have with hundreds of thousands of workers in labor intensive operations.
  
  This Taiwanese success drove an economic restructuring in the United States. It allowed multinational companies to focus on research and development, branding and distribution. Today, a U.S. brand company can dream up a product and order it from a Taiwanese company with factories in China as easily as ordering a pizza from Pizza Hut. Without Taiwanese factories in China, it is hard to believe that Wal-Mart and Apple, the era's quintessential creatures, could have become as successful as they are.
  
  This sustainability of this profitable relationship between U.S. brand and distribution companies and Taiwanese factories is based on a Chinese labor force that continues to be plentiful and willing to accept working conditions.
  
  How Much Longer?
  
  In early 1990s, when I was working in Latin America, I became bullish on China's future. I saw Chinese workers would go much farther than elsewhere to earn a little money for two reasons: a cultural acceptance of "eating bitterness" in life; and familial obligations.
  
  The girls at the factory I visited were earning US$ 100 a month, which was not a bad wage. That money could be used to pay for a younger brother's tuition, a mother's medical bill and, if circumstance permitted, building a house for the whole family. Each worker was willing to sacrifice herself for the family; she was not living for herself. Essentially, she accepted hardship.
  
  These factors have changed. Today's young adults are less willing to eat bitterness. They are the first generation to grow up during prosperity, without worrying about food and shelter. Many were pampered by parents sensitive to the one-child policy. They are more like counterparts in other countries, which is good for China's international relations.
  
  Moreover, rural families are not desperate as they were a decade ago. Siblings are few, and the government pays much more for rural education. Health insurance is decreasing the numbers of families facing financial crises due to sickness. Most rural families have built houses. And familial obligations for today's rural youth are not as urgent as in the past.
  
  Meanwhile, inflation has severely eroded income value. Today's rural youth aspire to live in big cities, yet property prices in cities have grown twice as fast as wages. Dreams of owning a house in a comfortable city are becoming more distant.
  
  Recent events at Foxconn and Honda factories are symbols of this new China. The labor force isn't as plentiful or compliant as before, and the ways that governments and businesses are handling the situations expose their ignorance of a new reality. They still think these are isolated incidents and, through pressure and bribery (such as a little wage increase for all and then firing rebel leaders) can bring the situation back to normal.
  
  They think this way because of a generation gap, and the unusual relationship between local governments and businesses in China. The economy has raced three times faster than western economies did a century ago, and the generation gap seems three times larger as well. Today's young adults and their parents may as well be from different centuries. But government and business leaders are all from the parental generation, handling labor crises from this old perspective.
  
  The governing class judges everything on short-term, marginal economic improvement rather than according to dreams and long-term goals. Today's young people are more concerned about what will happen to them in the future. They want to settle down in big cities and have interesting, well-paying jobs – just like their counterparts in other countries. This vast generation gap in perception is the force behind social tension over China's property bubble as well as factory working conditions.
  
  The current factory system is unable to realize the dreams of today's young people. China's factories are often in isolated locations and self-contained. Youths who leave villages for these jobs find themselves more isolated than at home, with little hope of integration into urban communities. Indeed, they are neither in city or village. It's the most isolated life possible.
  
  The compensation system makes their lives extremely difficult as well. Base pay is low, and only with massive overtime can they expect close to 2,000 yuan a month. They have no time for self improvement or integrating into modern urban life. In a few years, they will lose their youth and jobs, but they still will not have the ability or financial resources to live in cities.
  
  Business leaders and government officials, of course, are asking why these workers aren't willing to accept these conditions, like the workers of a decade ago. They grew up in poverty and rule the country with a view that marginal economic improvement is the purpose of life. They don't appreciate, however, that times have changed: The previous generation focused on economic benefits for relatives in villages, not their own futures.
  
  The unusual relationship between factory owners and local governments makes it difficult to resolve or prevent labor problems. Most coastal factories have workers from interior provinces. The governments have few ties to workers, but they are very connected to factory owners through tax revenues and other benefits. Local governments, therefore, side with the businesses when dealing with workers.
  
  To improve the situation, the central government should limit these major, isolated factory sites. In the future, they should be located close to cities. As in other countries, workers should be encouraged to rent housing rather than live in factory dormitories. They should have a chance to integrate into urban life.
  
  For example, future factories should locate close to provincial capitals such as Changsha, Chengdu, Hefei and Nanchang, which until now have been supplying workers for coastal regions. As a general rule, these cities should discourage factory dormitories but instead build public transportation systems to link factories and residential areas.
  
  For many, these sorts of solutions to China's labor challenges may be apparent. But government and business leaders may not understand them at all. They are blinded by the urge to continue operating within the confines of the old model while protecting businesses from potential buyers in the West. So, when dealing with crises such as those at Foxconn and Honda, they try temporary fixes.
  
  I'm afraid similar yet greater problems will eventually surface. Ultimately, market force will bring down the current system. Workers don't have to show up for factory jobs. They can join the urban service sector instead, where wages may be a bit lower but lifestyles are much better, and have a chance to integrate into urban life.
  
  Rising labor costs will ultimately force factories closer to labor sources, and working conditions will turn more humane. The biggest losers will be coastal governments that side with the factories to protect their revenues. If they refuse to change, they will lose the factories and all those nimble fingers.

Source: http://english.caing.com/2010-06-07/100150460.html

Andy Xie: Shanghai Stock Market Is The Poor Man Casino

On Businessweek recently:

• May 24 (Bloomberg) -- A bartender at my neighborhood pub recently asked me how the Shanghai stock market was performing. I said it was at about 2,600 points. He jumped and said, “No! The Communist Party wouldn’t let that happen.”
  
  He spent the next 10 minutes trying to convince me that the Communist Party would make the market rise to 8,000 in the next three to five years.
  
  “Look, the Hong Kong market is at 20,000,” he said. “Shanghai at 8,000 would be very reasonable.”
  
  China’s stock market involves more investors than any other market in the world. There are 124 million brokerage accounts. From what I can gather, the collective enthusiasm of the investing community is still quite strong. The market capitalization is small at 53 percent of gross domestic product and 31 percent of money supply. Prices are at a historical low of 2.5 times book value. Why is the market still going down?
  
  When the central government introduced tightening measures for the real-estate market, many were hopeful the money would flow out of property into the stock market. A popular yo-yo theory says money travels only between property and the stock market, never anywhere else. The property market hasn’t dropped much, while the stock market is down 20 percent.
  
  Soft Landing
  
  Politics and liquidity drive China’s stock market. Neither is favorable. Though the government desires a soft landing, the bubble debate over the property market is over: Tightening is the consensus. The question is speed. When the government squeezes liquidity in the property market, it inevitably decreases it for the stock market. Both markets lose.
  
  The stock-market pain isn’t just collateral damage. Real-estate price appreciation is the biggest source of profit for businesses, especially in the financial industry. The total stock of properties, work-in-progress, and land banks may exceed three times GDP in value. When the price rises 20 percent, the gain is 60 percent of GDP.
  
  In a normal economy, corporate profit is about 10 percent of GDP. When capital appreciation is six times that, businesses try to play financial games to turn appreciation into accounting profit. When property prices stop rising, or even fall, very profitable companies suddenly become unprofitable.
  
  The state-owned banks are lining up for mega fund-raising of as much as 500 billion yuan ($73 billion) in the stock market. While two-thirds is supposed to be raised in Hong Kong, one-third is still a lot for the A-share market on the mainland to bear. About 456 billion yuan was raised in all of 2009.
  
  Bank Shares
  
  Banks are normally profit machines. But in one day they can lose it all. A good moment to buy bank stocks is right after a banking crisis. But when lenders are trying to raise so much capital to prepare for a property-market correction, it may not be the best moment to purchase shares in banks.
  
  Valuations have never presented a strong case to enter China’s stock market. They are now getting there. The current price-to-book ratio isn’t cheap, but it’s reasonable by international standards. I advise you not to pay too much attention to price-earnings ratios. Asset bubbles can distort them so much. The decline in valuation, however, may just be part of a normalization process.
  
  For a long time, China’s stock market behaved like an Internet stock with a small free float. The recent reforms have made all the shares liquid. Maybe China’s valuations are becoming normal because stocks aren’t valued by off-market trading at a discount anymore. It is a sign of progress. The conclusion: The Shanghai market won’t head back to its record of almost 6,000 points anytime soon. That will disappoint many.
  
  Market Crash
  
  Rich people aren’t in the stock market anymore. They are in the property market. An overwhelming majority believe real- estate prices only go up, not down. The people in the market today have no recollection of the market crash of 1997.
  
  The stock market, on the other hand, experienced a crash in 2007-08 -- from 6,000 points to less than 1,700 in one year. Those who can afford to play the property market find the stock market a bad place to be. This is why real estate has kept booming since 2007, while equities have been struggling. Of course, when the property market drops like shares did in 2007, the stock market will be treated more fairly.
  
  Stock-market investors in China often can’t afford to enter the real-estate market in big cities. They wish to get lucky, make enough money, and move on to the property market. This force caps the market upside, but not the downside.
  
  My bartender finally asked me to recommend a stock. He said he had 70,000 yuan and wanted to make enough money to buy a car.
  
  “I can’t buy a car with my wage income,” he said. “Look at how hard my job is. But, if I make 200,000 yuan in the stock market, I can buy a nice car.”
  
  As long as property prices don’t collapse, ordinary investors can forget about getting free lunches and new cars from the Chinese stock market. ( source: http://www.businessweek.com/news/2010-05-23/china-s-stock-market-has-become-a-poor-man-s-casino-andy-xie.html )
  

Andy Xie: Is The Market Right That We Will See A V-Shaped Bounce For Global Economy?

On the English Caijing, Andy Xie talks about the possibility of a W-shaped recovery, New Bubble Threatens a V-Shaped Rebound

• A growing liquidity bubble that ignores structural facts is the basis for today's happy talk about a comeback for the global economy.
  
  By Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Ltd.
  
  (Caijing Magazine) The United States is beginning to report data showing strong economic growth. Analysts are upgrading their outlooks for the U.S. economy, which is expected to grow at an annualized pace of 3 to 4 percent. And even before the U.S. revival emerged in the third quarter, China's data pointed toward a quick rebound in the second quarter.
  
  Is the global economy staging a V-shaped bounce? The buoyant financial market had been expecting a rebound for months. Was the market right?
  
  At the end of last year, I said I expected global stock markets to stage a big bounce in spring 2009, and the global economy to rebound in the second half. I also expected analysts to upgrade outlooks by this time. I warned that the economic pickup was due to inventory cycle and stimulus, and that the global economy would experience a second dip in 2010.
  
  In a normal economic cycle, an inventory-led recovery would be followed by corporate capital expenditure, leading to employment expansion. Rising employment leads to consumption growth, which expands profitability and more capex. Why won't it work this time? The reason, as I have argued before, is that a big bubble distorted the global economic structure. Re-matching supply and demand will take a long time.
  
  The process is called Schumpeterian creative destruction. Keynesian thinking ignores structural imbalance and focuses only on aggregate demand. In normal situations, Keynesian thinking is fine. However, when a recession is caused by the bursting of a big bubble, Keynesian thinking no longer works.
  
  Many policymakers actually don't think along the line of Keynes versus Schumpeter. They think in terms of creating another bubble to fight the recessionary impact of a bubble burst. This type of thinking is especially popular in China and on Wall Street. Central banks around the world, although they haven't done so deliberately, have created another liquidity bubble. It manifested itself first in surging commodity prices, next in stock markets, and lately in some property markets. Will this strategy succeed? I don't think so.
  
  The lifespan of a bubble depends on how it affects demand. The longest-lasting are property and technology bubbles. The multiplier effect of a property bubble is multifaceted, stimulating investment and consumption in the short term. The supply chain it impacts is very long. From commodity producers to real estate agents, it could stimulate more than one-fifth of an economy on the supply side. On the demand side, it stimulates credit growth and financial sector earnings, and often boosts consumption through the wealth effect. Because a property bubble is so powerful, the negative effects of a bursting are great. Excess supply created during a bubble's lifespan takes time to consume. And a bust destroys the credit system.
  
  A technology bubble occurs when investors exaggerate a new technology's impact on corporate earnings. A breakthrough such as the Internet improves productivity enormously. However, consumers receive most of the benefits. Competition eventually shifts temporarily high corporate profitability toward lower consumer prices. Because the emergence of an important technology brings down consumer prices, central banks often release too much money, which flows into asset markets and creates bubbles. While an underlying technology leads to an economic boom, the bubble feels real. More capital pours into the technology. That leads to overcapacity and destruction of profitability. The bubble bursts when speculators finally realize that corporate earnings won't rise after all.
  
  The cost of a technology bubble is essentially equal to the amount of over-investment involved. Because a technological breakthrough expands the economic pie, the costs of a technology bubble are easy to absorb. An economy can recover relatively quickly.
  
  A pure bubble tied to excess liquidity that affects one or many financial assets cannot last long. Its multiplier effect on the broad economy is limited. It could have a limited impact on consumption due to the wealth effect. As it neither stimulates the supply side nor boosts productivity, whatever story it is based on will have holes that become apparent to speculators. It doesn't take long for them to flee. Furthermore, a pure liquidity bubble without support from productivity can easily lead to inflation, which causes tightening expectations that trigger a bubble's burst.
  
  What we are seeing now in the global economy is a pure liquidity bubble. It's been manifested in several asset classes. The most prominent are commodities, stocks and government bonds. The story that supports this bubble is that fiscal stimulus would lead to quick economic recovery, and the output gap could keep inflation down. Hence, central banks can keep interest rates low for a couple more years. And following this story line, investors can look forward to strong corporate earnings and low interest rates at the same time, a sort of a goldilocks scenario for the stock market.
  
  What occurred in China in the second quarter and started happening in the United States in the third quarter seems to lend support to this view. I think the market is being misled. The driving forces for the current bounce are inventory cycle and government stimulus. The follow-through from corporate capex and consumption are severely constrained by structural challenges. These challenges have origins in the bubble that led to a misallocation of resources. After the bubble burst, a mismatch of supply and demand limited the effectiveness of either stimulus or a bubble in creating demand.
  
  The structural challenges arise from global imbalance and industries that over-expanded due to exaggerated demand supported in the past by cheap credit and high asset prices. At the global level, the imbalance is between deficit-bound Anglo-Saxon economies (Australia, Britain and the United States) and surplus emerging economies (mainly China and oil exporters). The imbalance was roughly equal to US$ 1 trillion, or 2 percent of global GDP. The imbalance was supported by: 1) the willingness of central banks in surplus, emerging economies to hold down exchange rates and recycle their surpluses into the deficit economies by buying government bonds; 2) the willingness of consumers in deficit countries to buy with borrowed money; and 3) Wall Street's ability to dress up high-risk consumer loans as low-risk derivative products. I am describing these factors to underscore that central banks are unlikely to bring back yesterday's equilibrium.
  
  Recent data point to a sharp increase in the household savings rate in the United States. Over two years, it rose above 5 percent from minus 2 percent. The current level is still below the historical average 8 percent. If normalization remains on track, it should rise above 8 percent, and probably reach above 10 percent, to bring debt levels down to the historical average.
  
  Some argue that, if low interest rates revive the property market, American households may be willing to borrow and spend again. This scenario is possible but not likely. The United States has not experienced serious property bubbles in the past because land is privately owned and plentiful. A supply overhang from one bubble takes a long time to digest. And American culture tends to swing to frugality after a bubble. One's outlook either for a normal recovery or a bubble-inspired boom depends on the outlook for the U.S. household savings rate. Unless the U.S. household sector is willing to borrow and spend again, emerging economies will not be able to revive the export-led growth model.
  
  If one accepts that the U.S. household savings rate will continue to rise, emerging economies must decrease their savings rates, increase investment, or decrease production. The best choice is to decrease savings rates. But savings rates are hard to change. They depend mainly on demographics and wealth levels. The quickest possible way out would involve creating an asset bubble that inflates household wealth and decreases savings. Many advocates of inflated property and stock markets in China have this effect in mind. Japan's bubble after the Plaza Accord in 1985 had its origin in the same dilemma. This approach, if it works, has catastrophic long-term consequences. Japan remains mired in stagnation two decades after its bubble began to burst.
  
  Some analysts are expecting China to repeat Japan's bubble experience, which occurred in the late 1980s. At that time, Japan's export-led growth model was stymied by a doubling of its currency value after the Plaza Accord. It tolerated a massive asset bubble to stimulate domestic demand and stabilize its economy. China's export-led model is facing a rising savings rate and declining U.S. demand for its exports. Asset inflation could be a way out in the short term.
  
  China doesn't need to repeat Japan's experience. One reason is that the circumstances are not the same. First, Japan was a developed country when its bubble started getting out of control in 1985. It couldn't divert its vast savings into infrastructure investment. But today, China's national urbanization project still has up to 30 percentage points to go. If the right mechanism can be implemented, China could divert more savings into urbanization.
  
  Second, China can decrease its savings rate substantially through structural reforms. Half of China's gross savings are in the public sector. The government and state-owned enterprises should decrease revenue-raising and increase borrowing to finance investments. For example, China's high property prices are based on the investment-fund revenue needs of local governments. If China's property prices were cut by one-third, the national savings rate could decrease by two to three percentage points.
  
  Third, the Chinese government could give its shares in listed state-owned enterprises to the household sector. The subsequent increase in household wealth could lower the national savings rate by three to four percentage points.
  
  China's exports are down by roughly one-fifth. It needs the national savings rate to fall by about six percentage points for the economy to function normally. Otherwise, the economy will experience either a recession or a bubble. And the purpose of a bubble, as mentioned, would be to temporarily decrease the savings rate.
  
  This discussion may seem to digress from the analysis of sustainability in the current economic recovery. But it brings out two points: The old equilibrium cannot be restored, and many structural barriers stand in the way of a new equilibrium. The current recovery is based on a temporary and unstable equilibrium in which the United States slows the rise of its national savings rate by increasing the fiscal deficit, and China lowers its savings surplus by boosting government spending and inflating an assets bubble.
  
  This temporary equilibrium depends on government action. It does not have a market foundation that would support sustained and rapid growth. Nevertheless, improving economic data will excite financial markets.
  
  China's stock market is cooling because the Chinese government is jawboning it down, based on fears of a big bubble downside. And the economy is beginning to slow. Markets outside China will likely do well for the next two months; diverging trends reflect that China's market recovered four months before others, and adjusts before others as well.
  
  Financial markets will turn down again when investors realize that the global economy will have a second dip in 2010, and that the U.S. Federal Reserve will raise interest rates soon. The turning point may well come sometime in the fourth quarter. By then, it would become apparent that China has slowed. U.S. unemployment will not have improved and, hence, its consumption will remain stagnant. And production data that's pushing expectations now will cool after the inventory cycle runs its course.
  
  Most analysts would argue that central banks won't raise interest rates before the recovery is on solid ground. The problem, though, is that fiscal stimulus can't resolve structural problems blocking a sustained recovery. Liquidity is the wrong medicine for the global economy right now. Overusing it encourages its side effect -- inflation.
  
  Conventional wisdom says inflation will not occur in a weak economy: The capacity utilization rate is low in a weak economy and, hence, businesses cannot raise prices. This one-dimensional thinking does not apply when there are structural imbalances. Bottlenecks could first appear in a few areas. Excess liquidity tends to flow toward shortages, and prices in those target areas could surge, raising inflation expectations and triggering general inflation. Another possibility is that expectations alone would be sufficient to bring about general inflation.
  
  Oil is the most likely commodity to lead an inflationary trend. Its price has doubled from a March low, despite declining demand. The driving force behind higher oil prices is liquidity. Financial markets are so developed now that retail investors can respond to inflation fears by buying exchange traded funds individually or in baskets of commodities.
  
  Oil is uniquely suited as an inflation hedging device. Its supply response is very low. More than 80 percent of global oil reserves are held by sovereign governments that don't respond to rising prices by producing more. Indeed, once their budgetary needs are met, high prices may decrease their desire to increase production. Neither does demand fall quickly against rising prices. Oil is essential for routine economic activities, and its reduced consumption has a large multiplier effect. As its price sensitivities are low on demand and supply sides, it is uniquely suited to absorb excess liquidity and reflect inflation expectations ahead of other commodities.
  
  If central banks continue refusing to raise interest rates during these weak economic times, oil prices may double from their current levels. So I think central banks, especially the Fed, will begin raising interest rates early next year or even late this year. I don't think it would raise rates willingly but wants to cool inflation expectations by showing an interest in inflation. Hence, the Fed will raise interest rates slowly, deliberately behind the curve. As a consequence, inflation could rise faster than interest rates, which is what the indebted U.S. household sector needs.
  
  This fool-the-market strategy may work temporarily. Its effectiveness must be reflected in oil prices; the Fed needs to target oil prices in its interest rate policy. If oil prices run from current levels, it means the market doesn't believe the Fed. That would force the Fed to raise interest rates quickly which, unfortunately, would trigger another deep recession.
  
  Instead of a V-shaped recovery, we may instead get a W curve. A dip next year, although perhaps not statistically deep, could deliver a profound psychological shock. Financial markets are buoyant now because they believe in the government. The second dip would demonstrate the limits of government power. The second dip could send asset prices down -- and keep them down for a long time.
  

Andy Xie: SSE Should Be 2000 Or Less!

Worried about the current correction in the Chinese Stock Markets? Chinese Stocks Plunge 6.7%; Japan Ends Down




On Bloomberg News: China Stocks ‘In Deep Bubble,’ May Drop 25%, Xie Says

• China Stocks ‘In Deep Bubble,’ May Drop 25%, Xie Says
  By Erik Schatzker and Allen Wan
  
  Aug. 31 (Bloomberg) -- China’s economy isn’t “sustainable” and the benchmark Shanghai Composite Index may fall another 25 percent, former Morgan Stanley Asian economist Andy Xie said in an interview.
  
  “The market is in deep bubble territory,” Xie, who correctly predicted in April 2007 that China’s equities would tumble, told Bloomberg Television.
  
  The Shanghai index plunged 6.7 percent to 2,667.75 today, the most since June 2008 and entering a bear market, on concern a slowdown in lending growth may derail a recovery in the world’s third-largest economy. Xie said the index “should be 2000 or less.”
  
  The Shanghai gauge slumped 22 percent this month, the worst performer among 89 benchmark indexes tracked by Bloomberg, as banks reined in lending to avert asset bubbles and policy makers advised industries such as steel and cement to curb overcapacity. The decline stopped a rally that had sent the measure up 103 percent from a November low on prospects the government’s 4 trillion yuan ($586 billion) stimulus program and a record amount of new credit would ensure the economy grows at least 8 percent this year.
  
  “The local market bears are convinced that tightening is already underway,” said Howard Wang, head of the Greater China team at JF Asset Management, which oversees $50 billion. Only “a very strong set of macro numbers in August” or “stronger statements from central authorities” would change this trend, Wang said.
  
  Global Tumble
  
  The tumble in China stocks send the MSCI World Index of 23 developed nations down 1 percent at 10:17 a.m. New York time. The Bank of New York Mellon China ADR Index, tracking American depositary receipts, lost 2.6 percent, led by commodity producers.
  
  At least 150 stocks on the 898-member Shanghai index dropped by the daily 10 percent limit. Industrial Bank Co. and Aluminum Corp. of China Ltd. tumbled by the permitted cap after Caijing magazine reported new loan growth this month may be almost half that of July. Lower profits dragged Baoshan Iron & Steel Co., the nation’s biggest steelmaker, and China Southern Airlines Co. down at least 7 percent.
  
  Chinese stocks are trading at the steepest discount in the world compared with analysts’ price targets after this month’s slump in the benchmark index.
  
  ‘Bright Spot’
  
  Equities in China remain “a bright spot” among global stocks because of the nation’s strong growth potential, Goldman Sachs Group Inc. said today.
  
  “We think the market concerns about a near-term ‘exit strategy’ appear premature as the government remains pro- growth,” Thomas Deng and Kinger Lau, analysts at Goldman Sachs, wrote in a research note.
  
  China may have 200 billion yuan of new loans in August, the Beijing-based Caijing reported today on its Web site. That compares with 7.4 trillion yuan for the first half of 2009 and 355.9 billion yuan in July alone. The government plans to tighten capital requirements for financial institutions, three people familiar with the matter said this month.
  
  An estimated 1.16 trillion yuan of loans were invested in stocks in the first five months of this year, China Business News reported June 29, citing Wei Jianing, a deputy director at the Development and Research Center under the State Council.
  

Yet Another Warning On China From Andy Xie

On Caijing.com China Counts Down to the Next Bubble Burst

• Naive retail investors and China itself will suffer a lot when the nation's overvalued property and asset markets collapse.
  
  By Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Ltd.
  
  Fueled by bank lending and inflation fears, China's stock and property markets have bubbled again. Odds are that both markets will adjust in the fourth quarter, although they might flare again next year.
  
  Fluctuations within a long-lasting bubble could be a dominant trend for the foreseeable future. But the bubble will eventually burst when the U.S. dollar becomes strong again, perhaps after inflation forces the Fed to raise interest rates.
  
  For now, I think Chinese stocks and properties are 50 to 100 percent overvalued. Chinese asset markets have become a giant Ponzi scheme, with prices supported by appreciation expectations. As more people and liquidity are sucked in, surging prices validate expectations, prompting more people to join the party.
  
  Typically, this sort of bubble ends when there isn't enough liquidity to continue feeding the beast. But liquidity isn't a constraint in China -- yet. Even though loans grew 24.4 percent in the first half this year in China, to 7.4 trillion yuan, the loan-deposit ratio increased only to 66.6 percent in June from 65 percent in December 2008. That means a lot of the borrowed money was not spent on activities in the real economy but merely supplied leverage for asset market transactions. China's property market is following a course very similar to what was seen in Hong Kong in 1997.
  
  The origin of China's asset bubble is excess liquidity, as reflected in high levels of foreign exchange reserves and low loan-deposit ratios. Excess liquidity is a serious problem, as underscored by low interbank interest rates. A weak dollar and strong exports led to this massive liquidity buildup, with the yuan falling as a dollar bear market began in 2002. Appreciation expectations drove liquidity into China, and today one-fourth of China's foreign exchange reserves could be due to this factor.
  
  China's productivity rose rapidly after it joined the World Trade Organization in 2001. Its massive infrastructure buildup and the relocation of manufacturers to China rapidly pushed up labor's productivity. At the same time, the value of the Chinese currency declined as it rose against the dollar. This combination of rising productivity and a weaker currency led to massive export growth. And the dollar earnings that resulted pumped up China's monetary system.
  
  Now, while China experiences weak exports, the weak dollar lets China release liquidity saved during the past five, boom years without worrying about currency depreciation. How far can the bubble grow, and for how long?
  
  It's not too hard to predict a timetable for a bubble burst. When the dollar becomes strong again, sufficient amounts of liquidity could leave China to pop the bubble. What's occurring in China now is no different from what happened in other emerging markets in the past: A weak dollar led to bubbles in hot, emerging economies, and when the dollar turned around, the bubbles inevitably burst.
  
  The timing of the next dollar turnaround is difficult to forecast. The dollar entered a bear market in 1985 after the Plaza Accord and bottomed 10 years later in 1995. It then rode a seven-year bull market, followed by the current bear market that began in 2002. Since then, the dollar index (DXY) has lost about 35 percent. If the last bear market is any guide, the current one could last until 2012. But there is no guarantee. The IT revolution started the most recent dollar bull market; odds are another technological revolution will be needed before a sustainable bull market for the dollar returns.
  
  However, monetary policy could trigger a short but powerful bull market for the dollar. In the early 1980s, the then-chairman of the Fed, Paul Volker, increased interest rates to double digits to contain inflation. Afterward, the dollar rallied hard. A Latin American crisis had a lot to do with that.
  
  The current situation is similar. As in the 1970s, the Fed is denying inflation risk due to its loose monetary policy. The longer the Fed waits, the higher inflation will peak. When inflation starts to accelerate, it could cause panic in financial markets. To calm the markets, the Fed would have to tighten aggressively, probably excessively, leading to a massive dollar rally. This would be the worst possible situation: A strong dollar and a weak U.S. economy. China's asset markets -- and the economy -- would almost surely see a hard landing.
  
  How far the bubble would go depends on the government's liquidity policy. The current bubble wave is very much driven by the government's encouragement for bank lending and super-low interbank interest rates. China could increase liquidity, as the Fed's interest rate is now zero, the dollar weak, China's foreign exchange reserves are high, and the loan deposit ratio is low. That would further expand the bubble. However, other considerations may prompt the government to cool things down.
  
  If the government pumps all the liquidity it can, it wouldn't have any ammunition left to pump again when it comes down. If by then the global economy has revived, the Chinese economy may have a soft landing with strong exports. Asset markets would certainly have a hard landing. However, if the global economy remains weak then, which is my view, both asset markets and the economy would have a hard landing. The political cost may be too great for the government to risk it all now.
  
  Less risky is a stop-and-go approach: The government releases a wave of liquidity, as we see now, and then turns off the tap. When it's all absorbed, markets run out of steam. When a tolerable bottom has been reached, the government can spark a revival by releasing another liquidity wave. This approach stretches out the ammunition and limits the size of the bubble, containing the damage of an eventual bubble burst. I suspect that would be the government's policy. If the global downturn continues for a few more years, China's property and stock markets could experience large, annual fluctuations. The next downward movement, ending the current wave of liquidity, may occur around National Day.
  
  Many would argue China isn't experiencing a bubble. They say high asset prices simply reflect China's high growth potential. And it's true that one can never make an ironclad case to pin down an asset boom as a bubble. But an element of judgment based on experience can help one distinguish a market boom from a bubble, and I've have had a reasonably good record at calling bubbles in the past. I wrote my doctoral thesis arguing that Japan's market was a bubble in the late 1980s, a long report for the World Bank in the early the 1990s arguing that Southeast Asia had a bubble, research notes at Morgan Stanley in 1999 calling the dotcom boom a bubble, and numerous research notes from 2003 onward arguing that the U.S. property market was a bubble. On the other hand, I've never called something a bubble that turned out not to be a bubble.
  
  I want to be perfectly clear about China's asset markets today: They are a big bubble, and their bursting will have very bad consequences for the country. However, as so many are enjoying what's going on, I don't think the government will act preemptively to eliminate the bubble. Indeed, many if not most in the policy circle argue the bubble is good for reviving the economy.
  
  This sort of thinking seems to work because the dollar is weak. That means a bubble can be revived with more liquidity after a cool-down. When the dollar revives, China's asset markets and, probably, the economy would have a hard landing. I hope people who advocate bubble benefits will stand up then to accept responsibility for the damage.
  
  The most basic approach to studying bubbles is to look at valuation, and the most important measures for property are price-to-income ratios and rental yields. China's nationwide average, per-square-meter price is quite close to the U.S. average. U.S. per capita income is seven times urban, per capita income in China. Yet the nationwide average price for a square meter in China is about three months' salary -- probably the highest in the world.
  
  As far as I can tell, a lot of properties can't be rented at all, and those that are rented bring a 3 percent yield, barely compensating for depreciation. The average yield from rentals, including those that can't be rented out, is probably negligible. China's property prices don't make sense from affordability or yield perspectives. Some argue that China's property is always like this: Appreciation is the return. This is not true. The property market fell dramatically from 1995 to 2001 during a strong dollar period.
  
  A special facet of China's property bubble is its role in local government finance. As land sales and taxes from property sales account for a big portion of local government revenues, governments have powerful incentive to pump up the property market. Land sales are often carefully managed to spike expectation. For example, those who bid extraordinarily high prices for land are laurelled as land kings. Of late, land kings are often state-owned enterprises. When SOEs borrow from state-owned banks and give the money to local governments at land auctions, why should the prices be meaningful? The money circulates in the government's big pocket. Tomorrow's non-performing loans, if land prices collapse, are just today's fiscal revenues. By chasing the skyrocketing land market, private developers that follow the SOEs' lead could be committing suicide.
  
  The stock market is again in a final frenzy. The most ignorant retail investors, dreaming of overnight riches, are being sucked in by the rising momentum. But retail investors usually lose, as the ones jumping in now will learn. A final frenzy usually doesn't last. Turning points in China are often linked to the political calendar; a popular belief among retail investors is that the government won't let the market fall before October 1, which is the 60th anniversary of the People's Republic of China. The last time this reasoning influenced the market was before the 17th Communist Party Congress in October 2007. This sort of belief is self-fulfilling in the short term, and the market tends to roll over on time. So if the past can provide meaningful guidance, the current wave will taper off before October.
  
  The idea that the government will not let the market fall is rooted in Chinese market psychology. In financial jargon, it is called a put option. During the era of Fed chairman Alan Greenspan, financial markets thought he would always bail out the markets in a crisis. That was the so-called Greenspan put. A parallel belief in China should be called the Panda put. However, in reality, the government can't reverse a market trend after it turns. The Chinese stock market has had big ups and downs in the past, which shows the government is unable to prevent a market fall. Nevertheless, this imaginary put option remains deeply rooted in popular psychology.
  
  Many policy thinkers think bubbles are not that harmful. One popular theory is that money passes from one person to another in a bubble and, as long as it remains in China, there is no permanent harm. Hence, if people are happy now and unhappy tomorrow, they just cancel out each other. But they should look at Japan and Hong Kong to see how much damage a bubble can do, even if money does not leak from a country.
  
  In a bubble, resources are diverted to bubble-making activities. These resources will be permanently wasted. For example, businesses in China are reluctant to focus on real economic activities and are devoting time and energy to market speculation. It means China may not have many globally competitive companies in the future. Even though China has had three decades of high growth, few companies are globally competitive, and serial bubble-making in the Chinese economy may be the reason.
  
  The current generation of young people includes many who are not interested in real jobs. Rather, they are addicted to stock market speculation. They see they value of their holdings change more in one day than they earn in one month, and have illusions of making a lot of money in the market. Of course, most will lose everything and may take extreme action afterward. The social consequences could be quite serious.
  
  A property bubble usually leads to overbuilding, and empty buildings represent permanent losses. Most people would laugh at such a possibility in China. After all, 1.3 billion people should need an unlimited amount of property. The reality is quite different. China's urban living space is 28 square meters per person, quite high by international standards. China's urbanization is about 50 percent, and could rise to 75 percent. Afterward, the rural population would decline on its own due to ageing. So China's urban population may rise by another 300 million people. If we assume that all can afford property (a laughable notion at today's prices), Chinese cities may need an additional 8.4 billion square meters of space. China's works-in-progress covers more than 2 billion square meters. There is enough land out there for another 2 billion. The construction industry has production capacity of about 1.5 billion square meters per annum. Absolute oversupply – not enough people for all the buildings -- could happen quite soon. When that happens, the consequences may be quite severe. Property prices could fall precipitously, as Japan experienced in the past two decades, destroying the banking system.
  
  The most serious damage that a property bubble inflicts is that it changes demographics. High property prices bring down birth rates. When property prices recede after a bubble bursts, a low birth rate culture cannot be changed. Hong Kong, Japan, Korea and Taiwan all went through property bubbles during their development periods. Their birth rates fell during bubbles and didn't recover afterward, despite government incentives. China's one-child policy alone will lead to a demographic catastrophe in two decades. The property bubble makes the trend irreversible: When the government abandons the one-child policy, the birth rate will not see a meaningful impact. In two decades, China's population could be very old and declining. Of course, property prices would be very low and declining also.
  
  In addition to net losses, the bubble's redistribution aspect has serious social consequences. In a stock market bubble, most households lose and a few win big. China's wealth inequality is already very high, and bubbles make it worse. A sizable population in China -- even a majority -- may not have meaningful wealth even after urbanization is complete. This would lead to social instability. A market economy is stable and efficient when most a majority has meaningful wealth and, hence, a stake in the system.
  
  Today's market frenzy won't last long. The correction may happen in the fourth quarter. There could be another frenetic wave next year as China releases more liquidity. When the dollar recovers, possibly in 2012, China's property and stock markets could experience the kind of collapse seen during the Asian Financial Crisis.

ps: on the issue of overbuilding and empty buildings, do see the following posting from Prof. Pettis: Notes on a real estate trip in China

Andy Xie Calls It Speculative Inventory And NOT Commodity Stockpiling!

Here's another excellent article from Andy Xie.

Recently highlighted many times on this blog were comments made by many on the issue of China stockpiling of commodities such as iron core, crude oil and copper.

Now Andy is calling it as SPECULATIVE INVENTORY!

Blogged previously China The Commodity Stockpiling Nation!!

• Blogged yesterday: Would China Have A Debt Problem?. China's stockpiling issue was mentioned... There have been rumors and some evidence of stockpiling for months, and if this is the case, and of course if the stockpiling is not sustainable, then the import numbers are likely to have been artificially boosted. Real demand by China for foreign goods will have actually been much lower.

And in the posting Would China Have A Debt Problem?, Professor Michael Pettis address the potential debt problem in China too!

All these are mentioned too by Andy Xie.

• Fear the Dark Side of China's Lending Surge
  06-19 14:24 Caijing
  
  Banks loans designed to spark economic recovery have been channeled into asset speculation, doing more harm than good.
  
  By Andy Xie
  
  (Caijing.com.cn) China's credit boom has increased bank lending by more than 6 trillion yuan since December. Many analysts think an economic boom will follow in the second half 2009. They will be disappointed. Much of this lending has not been used to support tangible projects but, instead, has been channeled into asset markets.
  
  Many boom forecasters think asset market speculation will lead to spending growth through the wealth effect. But creating a bubble to support an economy brings, at best, a few short-term benefits along with a lot of long-term pain. Moreover, some of this speculation is actually hurting China's economy by driving asset prices higher.
  
  The current surge in commodity prices, for example, is being fueled by China's demand for speculative inventory. Damage to the domestic economy is already significant. If lending doesn't cool soon, this speculative force will transfer even more Chinese cash overseas and trigger long-term stagflation.
  
  Commodity prices have skyrocketed since March. The Reuters-Jefferies CRB Index has risen by about one-third. Several important commodities such as oil and copper have doubled in value from this year's lows. As I have argued before, demand from financial buyers is driving commodity prices. The weak global economy can't support high commodity prices. Instead, low interest rates and inflation fears are driving money into commodity buying.
  
  Exchange-traded funds (ETFs) alone account for half of the activity on the oil futures market. ETFs allow retail investors to act like hedge funds. This product has serious implications for monetary policymaking. One consequence is that inflation fears could lead to inflation through massive deployment of money into inflation-hedging assets such as commodities.

In the posting Which Crude Oil ETF/ETN? DXO, USO or USF? I had mentioned 'Now here is an article that must be read also from Jesse. Is the USO Oil Fund "Like a Pyramid Scheme?"' Do give it a read. :D

• Financial demand alone can't support commodity prices. Financial investors can't take physical delivery and must sell maturing futures contracts. This force can lead to a steep price curve over time.
  
  Early this year, the six-month futures price for oil was US$ 20 higher than the spot price. Investors faced huge losses unless spot prices rose. A wide gap between spot and futures prices increased inventory demand as arbitrageurs sought to profit from the difference between warehousing costs and the gap between spot and futures prices. That demand flattened the price curve and limited losses for financial investors. Without inventory demand, financial speculation doesn't work.

Yeah.. remember the oil contango issue. Remember how buying into crude oil back in March was a rather no brainer? :p2

Now? It's a different ball game. The risk in the equation has changed. :D

• For some commodities, warehousing costs are low, limiting net losses for financial buyers. Some commodities can be used just like stocks, bonds and other financial products. Precious metals, for example, are like that. Copper, although 5,000 times less valuable than gold, still has low warehousing costs relative to its value. Some commodities such as lumber and iron ore are bulky, costly to warehouse, and should be less susceptible to financial speculation. Chinese players, however, are changing that formula by leveraging China's size. They've made everything open to speculation.
  
  There's little doubt that China's bank lending since last December has driven speculative inventory demand for commodities. Chinese banks lend for commodity purchases, allowing the underlying commodities to be used as collateral. These loans are structured like mortgages.
  
  Banks usually have to be extremely cautious about such lending, as commodity prices fluctuate far more than property prices. But Chinese banks are relatively lenient. As an industrializing economy, China's support for industrial activities such as raw material purchases for production is understandable. However, when commodities are bought on speculation, lenders face high risks without benefiting the economy. In some cases, this practice hurts banks and the economy at the same time.
  
  Speculative demand for iron ore, for example, is seriously hurting China's national interests. Rio Tinto risked bankruptcy following its overpriced, debt-financed takeover of Alcan. When iron ore prices fell by two-thirds from the peak, the market started getting worried about Rio Tinto's viability, and its share price sank.
  
  Chinalco then negotiated a US$ 19 billion investment in Rio Tinto. After that, Rio Tinto's share price nearly tripled. Rio Tinto then decided to issue new shares and cancel the Chinalco investment. Chinalco essentially gave Rio Tinto a free call option, and was ditched when a better option became available. The issue is why its share price has done so well.
  
  The international media has been following reports of record commodity imports by China. The surge is being portrayed as reflecting China's recovering economy. Indeed, the international financial market is portraying China's perceived recovery as a harbinger for global recovery. It is a major factor pushing up stock prices around the world.

LOL!!!

I chuckled as I read this part.

Rather spot on!!!!!

Even our so-called local expert got into the act back in March.

Which local expert? iCapital mah.

Do give this past posting a nice read. Can China Lead The World Out Of Recession?

• But China's imports are mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China's army of speculators is driving up prices, making their expectations self-fulfilling in the short term.
  
  The failure of Chinalco's investment in Rio Tinto has been costly for China. After watching its share price triple, Rio Tinto saw it could raise money more cheaply by issuing new shares to pay down debt. The potential financial loss to Chinalco isn't the point. Rather, higher costs will stem from a further monopolization of the iron ore market because Rio Tinto, after scrapping the Chinalco deal, entered into an iron ore joint venture with BHP Billiton. Even though these two mining giants will keep separate marketing channels, joint production will allow them to collude on production levels, significantly impacting future ore prices.
  
  The iron ore market has been brutal for China, partly due to China's own inefficient system. China imports more ore than Europe and Japan combined. Skyrocketing prices have cost China dearly.
  
  For four decades before 2003, fine iron ore prices fluctuated between US$ 20 and US$ 30 a ton. As ore was plentiful, prices were driven by production costs. After 2003, Chinese demand drove prices out of this range. Contract prices quadrupled to nearly US$ 100 per ton, and the spot price reached nearly US$ 200 a ton in 2008.
  
  The gradual concentration of major iron ore mines by the world's three largest suppliers was a major reason for this price increase. The nature of Chinese demand was another major reason. China's steel production capacity has skyrocketed, even though capacity is fragmented.
  
  China's local governments have been obsessed with promoting steel industry growth, which is the reason for fragmentation. Huge demand and numerous small players are a perfect setup for price increases by the Big Three miners, which often cite high spot prices as the reason for jagging up contract prices. But the spot market is relatively small, and mines can easily manipulate spot prices by reducing supply. On the other hand, numerous Chinese steel mills simultaneously want to buy ore to sustain production so their governments can report higher GDP rates, even if higher GDP is money-losing. China's steel industry is structured to hurt China's best interests.
  
  As steel demand collapsed in the fourth quarter 2008 and first quarter 2009, steel prices fell sharply. That should have led to a collapse in ore demand. But the bank lending surge armed Chinese ore distributors, giving them money for speculating and stocking up. That significantly strengthened the hand of the Big Three. The tie-up of BHP and Rio Tinto further increased their monopoly power. Even though China is the biggest buyer of ore by far, it has had no power in price setting. The global recession should have benefited China. Instead, the lending surge worsened China's position by financing Chinese speculative demand.
  
  China is a resource scarce economy. Its import needs will only increase. International suppliers are trying to take advantage of the situation by consolidating. But Chinese buyers are fragmented due to local government protection. China's lending surge made matters worse by creating excessive speculative demand.
  
  What is happening in the commodity market is glaring proof that China's lending surge is hurting the country. Even more serious is that it is leading Chinese companies away from real business and further toward asset speculation – virtual business.
  
  The tough economy and easy credit conditions encouraged many companies to try profiting from asset appreciation. They borrowed money and put it into the stock market. And since China's stock market has risen 70 percent since last November, many businesses feel vindicated for focusing on the asset market. This speculation spread to Hong Kong. Mainland money may have been behind a recent rise in the Hang Seng Index to 19,000 from 15,000, as well as Hong Kong luxury property sales. One way or another, it seems the money source was China's lending binge.
  
  Borrowing money for asset market speculation is not restricted to private companies. State-owned enterprises (SOEs) appear to be lending money to private companies at high interest rates, i.e. loan sharking, using money borrowed at low rates from state-owned banks. Of course, we can't estimate the magnitude of such SOE lending. But it has replaced high interest rate financing in the gray economy.
  
  As the economy weakened in late 2008, private lenders began demanding money back from distressed private companies. Loans from state-owned enterprises may have kept many private companies from going bankrupt. It has served to re-channel bank lending into cash for individuals and businesses that were in the lending business. This money may have flowed into asset markets. It is part of the phenomenon of the private sector withdrawing from the real economy into the virtual one.
  
  It's worrisome that businessmen have become de facto fund managers and speculators. This happened 10 years ago in Hong Kong, and since then the city's economy has stagnated. Some may argue that China has SOEs to lead the economy. However, private companies account for most employment in China, even though SOEs account for a larger portion of GDP. Now, the government is spending huge amounts of money to provide temporary employment for 2009 college graduates. If private sector employment doesn't grow, the government may have to spend even more next year. The government is using fiscal stimulus and bank lending to support economic recovery. But the recovery may be a jobless one. China needs a dynamic private sector to resolve the employment problem.
  
  We are seeing a dark side to the lending surge as commodity speculation hurts the economy. More lending may lead to higher commodity prices, threatening stagflation. Cheap loans benefit overseas commodity suppliers, not necessarily the Chinese economy. Lending policy should consider this self-inflicted damage.
  
  Many analysts argue GDP growth follows loan growth, and inflation is a problem only when the economy overheats. This is naive. Borrowed money channeled into speculation leads to inflation. And China may face a lasting employment crisis if private companies don't expand.
  
  This lending surge proves China's economic problems can't be resolved with liquidity. China's growth model is based on government-led investment and foreign enterprise-led export. As exports grew in the past, the government channeled income into investment to support more export growth. Now that the global economy and China's exports have collapsed, there will be no income growth to support investment growth. The government's current investment stimulus is tapping a money pool accumulated from past exports. Eventually, the pool will dry up.
  
  If exports remain weak for several years, China's only chance for returning to high growth will be to shift demand to the domestic household sector. This would require significant rebalancing of wealth and income. A new growth cycle could start by distributing shares of listed SOEs to Chinese households, creating a virtuous cycle that lasts a decade.
  
  Putting money into speculative investments isn't totally irrational. It's better than expanding capacity which, without export customers, would surely lead to losses. Businesses currently lack incentive to invest. But many boom forecasters wrongly assume that recent asset appreciation, fueled by speculation, signaled an end to economic problems. That's an illusion. The lending surge may have created more problems than it resolved.

Remember these last few lines by Andy....

• But many boom forecasters wrongly assume that recent asset appreciation, fueled by speculation, signaled an end to economic problems. That's an illusion. The lending surge may have created more problems than it resolved.

Also, if you have the time to indulge on more reading, here's another interesting article from Professor Pettis. Stimulus – at what cost?

ps: the implications on the dry bulk sector is rather obvious yes? :D

Massive Market Warning From Andy Xie Again

Blogged previously on 29 April 2009. Why This Is Still A Bear Market!.

With markets having a pretty impressive May 2009, many would have shrug off Andy's comments.

However, on yesterday's Caijing.com, Andy Xie has another editorial Tight Spot for Fed, Blind Spot for Investors

• A combination of growth optimism and inflation fear has catapulted asset markets in the past few weeks. These two concerns should drive markets in different directions: Inflation fear, for example, should limit room for stimulus and prompt stock markets to retreat. But the investment camps expressing these opposite concerns go separate ways, each pumping up what seems believable. As a result, stock and commodity markets are mirroring the behavior seen during the giddy days of 2007.
  
  Regardless of what investors or speculators say to justify their punting, the real driving force is the return of animal spirit. After living in fear for more than a year, they just couldn't sit around any longer. So they decided to inch back. The resulting market appreciation emboldened more people. All sorts of theories began to surface to justify the market trend. Now that the rising trend has been around for three months globally and seven months in China, even the most timid have been unable to resist. They're jumping in, in droves.
  
  When the least informed and most credulous get into the market, the market is usually peaking. A rising economy and growing income produces more funds to fuel the market. But the global economy is now stuck with years of slow growth. Strong economic growth won't follow the current stock market surge. This is a bear market rally. People who jump in now will lose big.
  
  Over the past three weeks, the dollar dove while oil and treasury yields surged. These price movements exhibited typical symptoms of inflation fear, which is complicating policymaking around the world. The United States, in particular, could be bottled in. The federal government's fiscal stimulus and liquidity pumping by the Federal Reserve are twin instruments for propping up the bursting U.S. economy. The fiscal deficit could top US$ 2 trillion (15 percent of GDP) in 2009. That would increase by one-third the total stock of federal government debt outstanding. Such a massive amount of federal debt paper needs a buoyant Treasury to absorb. If the Treasury market is a bear market, absorption becomes a huge problem.
  
  U.S. Treasury Secretary Timothy Geithner recently visited China to, among other things, persuade China to buy more Treasuries. According to a Brookings Institution estimate, China holds US$ 1.7 trillion in U.S. Treasuries and GSE paper (about 15 percent of the total stock). If China stops buying, it could plunge the Treasury market into deep bear territory. If China does not buy, the Treasury market will get worse. But China can't prop up the market by buying.
  
  In the past few years, purchases by central banks around the world have dominated demand for Treasuries. Central banks have been buying because their currencies are linked to the dollar. Hence, such demand is not price sensitive. The demand level is proportionate to the U.S. current account deficit, which determines the amount of dollars held by foreign central banks. The bigger the U.S. current account deficit, the greater the demand for Treasuries. This is why the Treasury yield was trending down during the bulging U.S. current account deficit period 2001-'08.
  
  This dynamic in the Treasury market was changed by the bursting of the U.S. credit-cum-property bubble. It is decreasing U.S. consumption and the U.S. current account deficit. The 2009 deficit is probably under US$ 400 billion, halved from the peak. That means non-U.S. central banks have much less money to buy, while the supply is surging. It means central banks no longer determine Treasury pricing. American institutions and families are now marginal buyers. This switch in who determines price is shifting Treasury yields significantly higher.
  
  The 10-year Treasury yield historically averages about 6 percent, with about 3.5 percent inflation and a real yield of 2.5 percent. This reflects the preferences of marginal buyers in the United States. Foreign central banks have pushed down the yield requirement substantially over the past seven years. If marginal buyers become American again, as I believe, Treasury yields will surge even higher from current levels. Future inflation will average more than 3.5 percent, I believe. Some policy thinkers in the United States believe the Fed should target inflation between 5 and 6 percent. The Treasury yield could rise to between 7.5 and 8.5 percent from the current 3.5 percent.
  
  A massive supply of Treasuries would only worsen the market. The Federal Reserve has been trying to prop the Treasury market by buying more than US$ 300 billion – a purchase that's backfired. Treasury investors are terrified by the inflation implication of the Fed action. It is equivalent to monetizing national debt. As the federal deficit will remain sky-high for years to come, the monetization could become much larger, which might lead to hyperinflation. This is why the Treasury yield has surged in the past three weeks.
  
  One possible response is to finance the U.S. budget deficit with short-term financing. As the Fed controls short-term interest rates, such a strategy could avoid the pain of high interest rates. But this strategy could crash the dollar.
  
  The dollar index-DXY has fallen 10 percent from the March level, even though the U.S. trade deficit has declined substantially. It reflects the market's expectations that the Fed's monetary policy will lead to inflation and a dollar crash. The cause of dollar weakness is the outflow of U.S. money, in my view. It is the primary cause of a surge in emerging markets and commodities. Most U.S. analysts think the dollar's weakness is due to foreigners buying less of it. This is probably incorrect.
  
  The dollar's weakness can limit Fed policy options. It heightens inflation risks; a weak dollar imports inflation and, more importantly, increases inflation expectations, which can be self-fulfilling in today's environment. The Fed has released and committed US$ 12 trillion (83 percent of GDP) for bailing out the financial system. This massive overhang in money supply could cause hyperinflation if not withdrawn in time. So far, the market is still giving the Fed the benefit of the doubt, believing it will indeed withdraw the money. Dollar weakness reflects the market's wavering confidence in the Fed. If the wavering continues, it could lead to a dollar collapse and make inflation self-fulfilling.
  
  The Fed may have to change its stance, even using token gestures, to assure the market it won't release too much money. For example, signaling rate hikes would soothe the market. But the economy is still in terrible shape; unemployment may surpass 10 percent this year. Any suggestion of hiking interest rates would dampen growth expectations. The Fed is caught between a rock and a hard place.
  
  Oil prices have doubled since a March low, even though global demand continues to decline. The driving forces again are expectations of inflation and a weaker dollar. As U.S.-based funds flee, some of the money has flowed into oil ETFs. This initially impacted futures prices, creating a huge gap between cash and futures prices. The gap increased inventory demand as investors tried to profit from the gap. Rising inventory demand caused spot prices to reach parity with futures prices. Rising oil prices, though, lead to inflation and depress growth. It is a stagflation factor. If the Fed doesn't rein in weak dollar expectations, stagflation will arrive sooner than I previously expected.
  
  Stagflation in the 1970s spawned the development of rational expectation theory in economics. Monetary stimulus works by fooling people into believing in money's value while the central bank cheapens it. This perception gap stimulates the economy by fooling people into demanding more money than they should. Rational expectation theory clarified the underpinning for Keynesian liquidity theory. However, as they say, people can't be fooled three times. Central banks that tried to use stimuli to solve structural problems in the '70s saw their stimuli didn't work. People saw through what they tried again and again, and began behaving accordingly, which translated monetary stimulus straight into inflation without stimulating economic growth.
  
  Rational expectation theory discredited Keynesian theory and laid the foundation for Paul Volker's tough love policy, which jagged up interest rates and triggered a recession. The recession convinced people that the central bank was serious about cooling inflation, so they adjusted their behavior accordingly. Inflation expectations fell sharply afterward. The credibility that Volker brought to the Fed was exploited by Alan Greenspan, who kept pumping money to solve economic problems. As I have argued before, special factors made Greenspan's approach effective at the same. Its byproduct was asset bubbles. As the environment has changed, rational expectation theory will again exert force on the impact of monetary policy.
  
  Movements in Treasury yields, oil and the dollar underscore the return of rational expectation. Policymakers have to take actions to dent the speed of its returning. Otherwise, the stimulus will lose traction everywhere, and the global economy will slump. I expect at least gestures from U.S. policymakers to assuage market concerns about rampant fiscal and monetary expansion. The noise would be to emphasize the "temporary" nature of the stimulus. The market will probably be fooled again. It will fully wake up only in 2010. The United States has no way out but to print money. As a rational country, it will do what it has to, regardless of its rhetoric. This is why I expect a second dip for the global economy in 2010.
  
  While inflation expectations are causing some in the investor community to act, the rest are betting on strong economic recovery. Massive amounts of money have flowed into emerging markets, making it look like a runaway train. Many bystanders can't take it any longer and are jumping in. Markets, after trending up for three months, are gapping up. Unfortunately for the last-minute bulls, current market movements suggest peaking. If you buy now, you have a 90 percent chance of losing money when you try to get out.
  
  Contrary to all the market noise, there are no signs of a significant economic recovery. So-called green shoots in the global economy are mostly due to inventory cycles. Stimuli might juice up growth a bit in the second half 2009. Nothing, however, suggests a lasting recovery. Markets are trading on imagination.
  
  The return of funds flowing into property is even more ridiculous. A property burst usually lasts for more than three years. The current burst is larger than usual. The property market is likely to remain in bear territory for much longer. The bulls are talking about inflation as the bullish factor for property. Unfortunately, property prices have risen already and need to come down even as CPI rises. Then the two can reach parity.
  
  While rational expectation is returning to part of the investment community, most investors are still trapped by institutional weakness, which makes them behave irrationally. The Greenspan era has nurtured a vast financial sector. All the people in this business need something to do. Since they invest other people's money, they are biased toward bullish sentiment. Otherwise, if they say it's all bad, their investors will take back the money, and they will lose their jobs. Governments know that, and create noise to give them excuses to be bullish.
  
  This institutional weakness has been a catastrophe for people who trust investment professionals. In the past two decades, equity investors have done worse than those who held U.S. market bonds, and who lost big in Japan and emerging markets in general. It is astonishing that a value-destroying industry has lasted so long. The greater irony is that salaries in this industry have been two to three times above what's paid in other sector. The key to its survival is volatility. As markets collapse and surge, possibilities for getting rich quickly are created. Unfortunately, most people don't get out when markets are high, as they are now. They only take a ride.
  
  Indeed, most people who invest in the stock market get poorer. Look at Japan, Korea and Taiwan: Even though their per capita incomes have risen enormously over the past three decades, investors in these stock markets lost money. Economic growth is a necessary but not sufficient condition for investors to make money in the stock market. Most countries, unfortunately, don't possess the conditions for stock markets to reflect economic growth. The key is good corporate governance. It requires rule of law and good morality. Neither is apparent in most markets.
  
  It's a widely accepted notion that long term stock investors make money. Actually, this is not true. Most companies don't last for more than 20 years. How can long term investment make money for you? The bankruptcy of General Motors should remind people that this notion is ridiculous. General Motors was a symbol of the U.S. economy, a century-old company that succumbed to bankruptcy. In the long run, all companies go bankrupt.
  
  Property on the surface is better than the stock market. It is something physical that investors can touch. However, it doesn't hold much value in the long run either. Look at Japan: Its property prices are lower than they were three decades ago. U.S. property prices will likely bottom below levels of 20 years ago, after adjusting for inflation.
  
  China's property market holds even less value in the long run. Chinese properties are sitting on land leased for 70 years for residential properties and 50 years for commercial properties. Their residual values are zero at the end. The hope for perpetual appreciation is a joke. If you accept zero value at the end of 70 years, the property value should only be the use value during those 70 years. The use value is fully reflected in rental yield. The current rental yield is half the mortgage interest rate. How could properties not be overvalued? The bulls want buyers to ignore rental yield and focus on appreciation. But appreciation in the long run isn't possible. Depreciation is, as the end value is zero.
  
  The world is setting up for a big crash, again. Since the last bubble burst, governments around the world have not been focusing on reforms. They are trying to pump a new bubble to solve existing problems. Before inflation appears, this strategy works. As inflation expectation rises, its effectiveness is threatened. When inflation appears in 2010, another crash will come.
  
  If you are a speculator and confident you can get out before it crashes, this is your market. If you think this market is for real, you are making a mistake and should get out as soon as possible. If you lost money during your last three market entries, stay away from this one – as far as you can.