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Is That The Sound Of Asset Bubbles Bursting?
Ben Bernanke's recent press conference and China's interbank market crash may appear to have little in common but the truth is rather different. For both the U.S. and China are trying to deflate asset bubbles caused by excessive money printing and interest rates being kept too low for too long. And politics is largely behind the timing of their decisions to clamp down on these bubbles. Bernanke is desperate to avoid the mistakes of his disgraced predecessor, Alan Greenspan, whose loose money policies blew up soon after he departed the post. And China's President Xi Jinping would rather have an economic slowdown now than later on so that he can blame it on his predecessor, Hu Jintao.
The question for investors is whether Bernanke or Xi will blink, choosing to reflate their asset bubbles (the U.S. bubbles are principally in stock and bond markets while China's are more broad-based) rather than face the consequences of unwinding them. At Asia Confidential, we're not certain of anything. But our best guess is that the U.S. economy is too fragile and deflationary forces are too strong for QE tapering to take place this year. China is a different matter as we now suspect the new president may just have the political backing and will to carry out tightening measures. Either way though, the asset bubbles in both countries are likely to deflate, it's just a matter of how and when this happens.
The context to market gyrations
What's behind the wild market gyrations of the past week? It's clear that the U.S. and China are attempting to deflate their asset bubbles and markets don't like it. To better understand why this is the case though, it's important to appreciate how these bubbles developed in the first place.
And to do that, we need to step back in time. All the way back to 1994, in fact. Why this year, you ask? Well, it's then that China devalued its currency by 50%. Asia Confidential believes that this singular event has been the key driver behind events leading up to the financial crisis and thereafter.
That's because the 1994 devaluation resulted in a substantial under-valuation of the yuan. This under-valuation created the conditions by which China was able to become an exporting powerhouse.
For China to become this powerhouse though, it needed buyers. The developed world was only too happy to oblige, scooping up the cheap Chinese products. It didn't matter that consumers in the developed world didn't have enough money to purchase all of these products. They simply piled on debt to pay for them.
The beauty of this arrangement was that China received U.S. dollars from U.S. consumers. Its subsequent trade surplus led to the rapid accumulation of foreign exchange reserves, which China used to buy U.S. government bonds. This in turn kept U.S. bond yields and interest rates low, making it cheap for U.S. consumers to take on more debt to buy Chinese products and other things (such as local property).
But to maintain its currency peg to the U.S. dollar, China had to create yuan through the printing press. This whole process helped created inflation at home and deflation abroad.
An elegant arrangement, no? Not so much. Since 2008, this seemingly virtuous circle has slowly unravelled as the developed world pays down its excessive debt load. Meantime, political pressure to appreciate the yuan has resulted in that currency recently reaching 19-year highs versus the dollar.
You're probably wondering what all of this has to do with the events of the past week. Well, the developed world has never paid back those excessive debts as governments thought that process would be too painful for their countries to take. Instead, those governments took over the private sector debts and printed loads of money to try to inflate these debts away.
That printed money has been used to buy U.S. government debt, which has depressed U.S. bond yields and interest rates. That's hurt savers, who've searched for better returns in risk assets, such as stock markets.
There's little doubt that the U.S. Federal Reserve's solutions to the 2008 crisis have provided artificial support to stock and bond markets. And undoubtedly to the U.S. housing market too. Bernanke is clearly worried about all this and it goes some way towards explaining his push to reduce U.S. stimulus.
Meanwhile, China's response to the 2008 crisis was to print 4 trillion yuan (close to US$600 million in 2009 terms) to pump prime its economy and prevent a downturn similar to the one which occurred in the developed world.
This pump priming went largely into fixed asset investments, financed principally via debt at the local government level. It's directly resulted in a property bubble of substantial proportions. It's also led to debt issues, with total credit to GDP in China increasing from 125% to 200% over the past five years.
China's new president came to power in March and inherited this mess. He's intent on deflating the credit bubble without crashing the economy. That intent is behind the spike in China's interbank interest rates in recent weeks.
Bernanke is focused on his legacy
Why is Bernanke choosing to act now to reduce stimulus then? Before getting to that, let's take a quick look at what he actually said at his press conference post the FOMC meeting. Bernanke suggested that QE cutbacks could begin later this year if growth picks up as the Fed projects, unemployment comes down and inflation comes closer to the central bank's 2% target. If those expectations bear out, the Fed could stop QE altogether by the middle of next year, when it forecasts unemployment to drop to 7%.
In short, Bernanke thinks the economy is improving to the point that it will be able to stand on its own without the assistance of stimulus. And this line has been parroted by the vast majority of the investment community.
But there appears to be more than a few holes in this argument:
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U.S. economic growth is mediocre at best, particularly when considering that it's coming out of such a deep downturn.
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The majority of recent data points on the economy has disappointed, indicating a slowing growth rate in the short term.
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If economic growth remains at current levels, or falls, Bernanke's unemployment targets won't be reached.
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The biggest issue of all is one that I have alluded to many occasions and only recently have other commentators started to pick up on: U.S. inflation is slowing and deflation remains the primary risk right now.
Under these circumstances, QE tapering would likely undo what remains a fragile economy.
If that's the case, why would Bernanke be pushing ahead with this tapering? We suspect that politics may have something to do with it. In a recent TV interview, President Obama all but said that Bernanke won't serve a third term as Fed Chairman from January next year.
This means that Bernanke, like any good politician (central bankers are as much politicians as they are economists), has one eye on his current job and the other eye on how he'll be remembered in the history books. He won't want to become another Alan Greenspan, who left office shortly before the 2008 financial crisis that he arguably contributed too.
Put bluntly, QE tapering - even a small reduction thereof - offers the chance for Bernanke to be remembered as the responsible central banker rather than the one who re-created asset bubbles that led to a further financial crisis.
Xi Jinping's iron fist
China has been the other focus of market attention, with good reason. The country's interbank market - where banks lend money to each other - essentially froze for a short period of time. And the central government initially refused to step in to provide the liquidity to get the market functioning again. It only caved in when things became critical.
Below is the Shanghai Interbank Offered Rate (SHIBOR) courtesy of Zero Hedge.
Sure, there were a number of factors which contributed to the spike in interbank rates, including:
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The gradual tightening in policy this year.
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A sharp fall in foreign exchange inflows in May due to a government crackdown on illicit activity.
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Banks hoarding cash for seasonal reasons.
But this crisis was principally caused by the central government stepping back and refusing to inject liquidity into the market.
There was a lot of silly commentary out of the U.S. about how this was China's "Lehman" moment - alluding to 2008, when Lehman Brothers went under, freezing U.S. credit markets. It ignored the fact that the central government largely initiated the interbank rate spike.
The obvious question is: why would the central government do this? And the logical explanation is that it wants banks to slow the pace of lending and this was its crude way of communicating the message. We think, though, that almost everyone has missed a key driver for the credit crackdown.
The government and its new leaders are no dummies. They realise that they inherited a mammoth credit bubble that's in the process of bursting. They have two choices:
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Reflate the credit bubble and risk enormous economic damage down the track.
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Or acknowledge that the economy will slow as the bubble pops and attempt to manage it as best they can.
No one knows for sure, but we suspect that the interbank event signals that Xi Jinping has chosen the latter path. The reason for this suspicion is that Xi appears a pragmatic, canny politician. He would have calculated that by having a serious economic slowdown now, the blame can justifiably pinned on his predecessor, Hu Jintao. A slowdown later on would afford him no such luxury.
In other words, Xi knows that China's credit bubble will burst. It's better to get it out of the way to preserve his authority. He can then get on with the job of introducing the crucial reforms needed to restructure the economy and drive growth over the next decade.
What happens from here?
You're probably thinking that this is all well and good, but what can we expect to happen from here? The truth is that no one knows. But here are a few tentative guesses:
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In the short run, the U.S. economy is unlikely to recover, weighed down by excessive debt. And deflation will remain the primary risk.
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China's economy may well have some encouraging weeks or months. For instance, upcoming data should be somewhat better given the accelerated banking lending in early June, rollout of significant infrastructure projects across several key cities and a normalisation in consumption following the Avian flu scare. However, the general economic trend will be down and it could well take a long time to recover.
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It's our expectation that Xi will positively surprise when he announces broad-ranging economic reforms, likely in the second half of this year. Substantive moves toward privatising state assets may be a centrepiece. It won't be hard for Xi to exceed the very low market expectations on this. Any reforms will do little to mitigate the current economic slowdown though.
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In the long-term, all the asset bubbles in the developed world and China will deflate in one way or another. All bubbles pop eventually and these ones will be no different. No central banker or leader can prevent this from happening. They can try, but they'll only succeed in delaying the process.
This post was originally published at Asia Confidential: http://asiaconf.com
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Deflation is not a "risk". It's a natural aspect of a properly functioning economy. when the economy inflates (as it has since Greenspaz), deflation is the ONLY way to restore it to health.
"Bernanke's Legacy"
Should read like any of the historic tragic downfalls via hubris.
With Turkey and Brazil serving as cautionary "breaking news" examples of what's in store for those who don't very very carefully deflate asset bubbles it's about time the US and China at least made a few half hearted motions in that direction. Both are lackadaisicle in their effrorts because hubris is a lot more comfortable and photogenic than stark drooling terror , and both of 'em like to think they've got unbeatable aces up their sleeves. China thinks it knows how to quell social unrest with tanks , and the the USA thinks it knows knows how to quell it with Full Spectrum Bullshit . Both are dead wrong but why tell them now ? Like the old saying goes , never wake up a sleep-walker .
And as for the Bernank , puh-leez ! The fact that he thinks he'll even have a legacy just confirms what we already known. He's as stupid as a vanilla mud pie . Legacy requires sufficient social stability to allow folks some time to waste on thinking about yesterdays fools . . . and that ain't what's coming.
If China would find a way to increase wages for a sufficient number of people so that they could afford all those empty apartments there would be no housing bubble in China and less bad loans.
In some industries, like the auto industry (in which assembly line worker´s pay only amount to 10 % of the total cost in the US and Europe), it is quite easy to raise wages drastically without causing significant inflation. In early 1914, Henry Ford was able to double the pay his assembly line workers got to $5 a day. Since the entry-level Model T at that point sold for $440, 88 days of work was the equivalent of a new Model T. And that was almost 100 years ago. I suspect that it should be possible to raise wages drastically in some sectors in China, like the auto industry, which do not depend on the export markets.
The fact that it may be harder for the Chinese to raise wages in industries that depend on cheap labour and exports also highlights the problem with copying that growth model other Asian countries have used in the past. Since China has got a huge potential, domestic market I doubt that it is a smart strategy for China to depend on exports which depend on cheap labour. The Chinese would probably have been better off if they had built their own commercial aircraft rather than importing them and paid for them by exporting shoes. China probably had the capacity to design commercial aircraft 10 years ago. If they had begun designing them 10 years ago they would probably have been ready for mass production by now.
"Chinese Design" ... oxymoron
You make some excellent points, but even wise central planning has difficulty in outperforming the unfettering of individual actors amidst a sound and stable money supply. Better to speak to reigning in fractional reserve, rather than focusing on commercial aircraft production.
There is less difference between central planning and an almost genuine market economy like the pre-WWI US economy in which Henry Ford could raise wages to $5 a day than you may think.
The government in a slightly “managed” market economy, like in the US beginning with the Roosevelt administration, can accomplish very similar results as in a centrally planned economy by granting tax breaks and/or assistance to sectors in which they want too see more growth. Tax breaks is frequently used in the US. MITI in Japan has historically assisted the expansion of large Japanese companies in sectors where MITI had figured out that Japanese companies should expand.
To me, it seems as if entrepreneurs have introduced the most significant improvements of productivity in various fields of the economy over the past 300 years. Thomas Newcomen, James Watt and Matthew Boulton and Henry Ford were all entrepreneurs. The consumer market for computers was not invented by companies like IBM, which share many features with bureaucracies controlled by the government, although the first computers were created as the result of the demand from the government. But when you have the blueprints for how to proceed with productivity improvements of the economy it seems easier for governments to speed up the transformation of the economy either by tax incentives or various degrees of central planning. Large, bureaucratic companies which in some respects resemble government agencies, also seem more likely to be successful if they got the “blue-prints” or if they can buy an existing, smaller company, perhaps a so-called startup company.
No matter whether the Chinese choose tax incentives or more obvious means of central planning they got all the blue-prints on how to increase productivity and wages. And since they got the potentially largest domestic economy in the world I think that it should be a lot easier for them than for others to just copy what has been done in other countries in the past. The next step, to create a business environment in which capital, knowledge and ideas meet and create cutting edge solutions like when James Watt found his investors, is probably not as simple to accomplish. But I don´t think that it was a coincidence that James Watt and Thomas Newcomen created a company that could offer a significantly improved steam engine in Britain. The knowledge which the invention and improvements of the steam engine took was there. James Watt had been able to study mathematics and instrument-making and had a workshop at the university in Glasgow. Watt began exploring the possibilities to improve the power efficiency of Newcomen style steam engines when he repaired a model that belonged to the university. There were also investors like Thomas Newcomen who were willing to invest money in James Watt´s steam engine innovations rather than in some easier way to make money. You could be granted patents for inventions and innovations which meant that an investor or inventor could get legal protection for his investment. And the patent system worked, at least for those who had enough money. Despite these circumstances it was not by no means self-evident that James Watt would be able to attract enough capital. It took quite some time for Watt and Boulton to make their company profitable. Their heirs did not become richest in Britain. It was a contemporary banker family that became by far the richest family in Britain. And an early Watt investor, John Roebuck, went bankrupt. So we should be happy that James Watt was able to find investors at all.
My impression is that China shares the same problem as Europe and North America as regards the willingness of investors to invest in companies that increase productivity. But the tremendous malinvestment in real estate in China indicates that this problem has been greater in China. I suspect that there could have been more companies like Huawei in China if there had not been so much malinvestment in China.
I also suspect that the Chinese government one way or the other is behind most of the announced orders for the Comac C919, for which deliveries are scheduled to begin in 2016:
http://en.wikipedia.org/wiki/Comac_C919
Contrary to all malinvestment in real estate, the C919 is probably not a bad idea. Ryan Air has signed an agreement to co-operate on the development of the C-919. I suspect that China had the capacity to begin construction of an aircraft similar to the C919 5 to 10 years earlier than they actually did. Perhaps they waited too long since the Shanghai Y-10 seems to have been a bad aircraft and dated before the first flight took place. I know that there seems to have been some problems with the smaller Comac ARJ21 project which began in March 2002. But I suspect that if they had used the experience they had gained from Shanghai Y-10 they could probably have had the ARJ21 and the C919 ready for production by now. They don´t seem to have invested anything in the commercial aircraft industry in the period 1983-2002. I suspect that they could have resumed investments in the commercial aircraft industry earlier than they actually did and that they were too focused on copying the growth model of smaller Asian countries.
Why does Dora have a backpack and a map??
Is she an illegal alien?
I quit reading when the author talked about what Bernanke said as if he believed Ben was telling the truth.
Mark my words: Berstanke will be in Israel within three years after leaving.
Only way to avoid the guillotine.
Slightly OT, but people are asking re PRISM, etc. who's monitoring who, all kinds of global traffic is directed to Isreal via their acquisition of various web "security" firms.
"Since 2008, this seemingly virtuous circle has slowly unravelled as the developed world pays down its excessive debt load."
Seemingly, because it isn't a circle, it is a cycle, which has an up phase and a down phase. Thus it is never different this time.
"Bernanke is desperate to avoid the mistakes of his disgraced predecessor, Alan Greenspan, whose loose money policies blew up soon after he departed the post."
Too late. The math never changes.
...Bernanke, like any good politician (central bankers are as much politicians as they are economists), has one eye on his current job and the other eye on how he'll be remembered in the history books. He won't want to become another Alan Greenspan, who left office shortly before the 2008 financial crisis that he arguably contributed too.
Wimpy! Greenspan was the AUTHOR of the current problems, as we all know.
It is not arguable.
You are absolutely right, but when the balloon starts to descend, everyone (lead by BB and BHO) has to blow hot air.
A fitting repost. Dora's take on it all: http://www.youtube.com/watch?v=anGXld-4hCA
"Put bluntly, QE tapering - even a small reduction thereof - offers the chance for Bernanke to be remembered as the responsible central banker rather than the one who re-created asset bubbles that led to a further financial crisis."
Did some asshole really write this?