China Overheating, Shilling's part 3

China is hoping to cool its white- hot economy without
precipitating a recession. Doing so will be extremely difficult: Inflation
fears are growing, the government’s ability to respond is quite limited, and
China’s economic model, which leaves bureaucrats guessing about the market
effects of their directives, is ultimately untenable.

Inflation worries start with housing. With Chinese
exports curtailed by U.S. consumer retrenchment, capital spending
threatened by government restraints and excess capacity, and domestic spending
less than robust, housing has been China’s big generator of economic growth in
recent years. By some estimates, half of Chinese GDP is linked to real-estate
activity.

The government is fearful of rising prices, and has moved
to prevent speculation. Buyers must now put down 60 percent of the purchase
price on second homes, and 30 percent on first homes. The government is
pressing banks to contain mortgages, and some have raisedinterest rates. In
January, the mayor of Shanghai announced a new tax on property
transactions that may be copied nationwide as other officials attempt to cool
prices.

With these restraints in place, and with supply starting
to catch up with demand, housing sales have slowed. But this has not fully
curtailed China’s real-estate bubble: Housing starts rose about 40 percent last
year. Developers are rushing to build while they try to support faltering
prices by delaying completions and creating artificial shortages. Of course,
these efforts are difficult to maintain because they tie up capital in
uncompleted houses. Houses are now being built at about twice the rate they’re
being sold, well above earlier norms.

Huge Loans

A report this week by China’s National Audit Office found
that a significant chunk of bank loans made to provincial- government financing
vehicles were improperly funneled into property investments, contributing to a
debt load equal to some 27 percent of GDP. Other huge loans to state-owned
enterprises, intended to finance infrastructure, also reportedly went into real
estate and may be at risk.

With inventories soaring while demand softens, and the
government clamping down on speculation, a collapse of the housing bubble seems
increasingly likely.

Prices Rising

Housing isn’t the only area where signs of inflation are
popping up. In May, consumer prices increased 5.5 percent versus a year
earlier. In December, Chinese leaders agreed to “put stabilizing the overall
price level in a more prominent position” in their ranking of economic
priorities. In a country where many live at or below the poverty level, food
costs are obviously a major concern, and they jumped 11.7 percent in May from a
year earlier.

The government appears increasingly worried about social
unrest. In November, it said it was ready to impose price controls to reduce
inflation, especially on food and energy, and said it would help the poor with
higher welfare payments. The unrest continues and, significantly, has moved
from rural areas to the cities.

Income inequality also remains a problem. The flow of
Chinese to more prosperous urban areas has increased average living
standards, but the difference between the rich and the rest continues to widen.
In 2010, annual per-capita income was about $2,900 in cities and about $900 in
rural areas. (Adjusting for lower costs in rural areas reduces this gap.)

Limited Response

China’s ability to respond to these worries is extremely
limited. The central bank relies on adjusting reserve requirements and
limits on bank lending to implement monetary policy. Since January 2010, it has
raised reserve requirements 12 times (to 21.5 percent), while only increasing
the one-year lending rate four times (to 6.31 percent), to accommodate
inefficient state-enterprise borrowers, which provide a lot of jobs.

Finally, implementing any policy in an economy that is
partly government-controlled, partly market-driven is very difficult. In a
completely controlled economy, as China’s used to be, government leaders might
have made economically inefficient decisions, but their authority wasn’t
disputed. In an open economy, as in Singapore, the markets make the
decisions, and politicians have little involvement.

But under China’s current arrangement, officials making
major decisions have to guess what market reactions will result, then try to
mitigate the unintended consequences of their actions.

Unintended Consequences

With a managed floating exchange rate, for example,
officials have to estimate how much hot money will enter China in anticipation
of a stronger currency, and then determine how to neutralize the undesired
effects of this flow. Government policies that encourage exports and trade
surpluses have pushed China’s foreign-currency reserves to more than $3
trillion. Until recently, all the foreign-currency earnings of Chinese
exporters had to be traded in for yuan, but then the central bank was forced to
issue securities to sop up that money to avoid depreciation.

Similarly, the Chinese government sets yearly limits on
bank loans in advance, but leaves it up to the banks and demand to determine
the monthly lending pattern. So the banks rush to make loans early in the year
for fear that the government will reduce the limit in a midcourse correction.

I suspect that such a hybrid market system is too
unwieldy to allow the Chinese government to manage a soft landing for its
economy. By my reckoning, the Federal Reserve has tried 12 times in the
post-World War II era to cool an overheating economy without precipitating a
recession. It succeeded only once. Can the politically controlled Chinese
central bank, and the government leaders who really call the shots, be more
successful than the independent Fed?

That seems unlikely. And the consequences, for China and
the world economy, could be unfortunate. (Bloomberg)

Comments

[steve from virginia]

The real question is whether China tips into hyperinflation or a deflationary recession?

"Until recently, all the foreign-currency earnings of Chinese exporters had to be traded in for yuan,"

  Some dollars flow to the central bank and the rest flow into the Chinese underground or 'loan shark' economy where the yuan rate is affordable for highly stressed manufacturers. Beijing allows this otherwise there is insufficient liquidity by way of above- ground economy for the manufacturing sector.

The loan shark economy is also competition in the dollar/yuan forex market inside China. The loan sharks cannot print yuan, they have to 'buy' them with dollars, euros, whatever they have. This is a big driver of inflation in China along with the dollar/crude and dollar/commodity trades.

A Chinese economist was complaining to a friend of mine about QE and effect on dollar, bigger problem is ZIRP and dollar carry. This feeds China inflation while removing PBOC rate tool @ same time.

If China raises rates, more dollars flow to China overcoming rate constraint on yuan creation. Raising the ZIRPy US short interest rates would crash finance that  depends on the dollar carry.

China will continue to talk 'tightening' while printing. It has to, it needs liquidity. Loan shark economy is sucking yuan out of above- ground economy, see SHIBOR. High overnight rate represents demand for yuan that the ordinary credit market has difficulty answering.

There is no way out of this bind w/o finance players taking massive hit: Chinese/US developers, US banks .. er, taxpayers, ordinary Chinese, etc. I'm still looking for the hyperinflationary endgame in China: there is no indexing to Chinese obligations as in US.