Authored by Andy Xie, originally posted at Caixin Online,
China and the United States, the primary sources of economic stimulus since 2008, will begin to unwind their stimulus in 2014. The Fed's announcement of its first reduction in quantitative easing and China's rising interbank interest rate are signals of what is to come. The main driver for the unwinding is concerns of bubbles, not that economies are strong enough.
Unwinding stimulus, especially one so large and prolonged, is fraught with unintended consequences. Bubbles tend to pop, not deflate slowly. Even though authorities are calibrating their tightening steps carefully to achieve a smooth landing, financial turmoil due to a bubble bursting is possible, which may drag the global economy into another recession.
Even if no financial turmoil emerges, some assets are likely to come under strong pressure. The economies that depend on commodity exports and/or hot money to plug their current accounts may see their currencies under more pressure. The Australian dollar and Brazilian real are highly vulnerable. The Indian rupee is another weak currency. The Canadian dollar and Russian ruble may come under pressure too.
Stimulus and Growth
After the 2008 financial crisis broke out, I predicted widespread monetary and fiscal stimulus all around, and such stimulus wouldn't bring back sustainable and sound growth, eventually leading to another crisis. I also predicted that stimulus advocates will blame the failure on insufficient stimulus. My predictions are coming true halfway there. Another financial crisis will make them whole.
The magnitude of the United States' stimulus could be measured by national debt rising from 62 percent to 100 percent of GDP and the Federal Reserve's balance sheet more than tripling from 2007 to 2013. The impact on asset prices is reflected by a 60 percent increase in household wealth from the crisis low and 21.4 percent above the 2007 peak – a level considered a bubble that led to the 2008 financial crisis. During the same period the U.S. economy has expanded by 6 percent in real terms and 15.8 percent in nominal terms. The current level of total employment is still below the pre-crisis level. It is obvious that the U.S. stimulus policy has had an outsized impact on asset prices and small one on the real economy or employment.
Why would the Fed decrease its QE while the economy is far from healthy? When the Fed first sounded its tightening warning in June, I argued that it was trying to manage an asset bubble. Before 2008, property appreciation was driving the U.S. bubble. Financial markets have been doing the job since. It appeared that the U.S. stock market was ready to spike like in early 2000 when the Fed sounded its warning. The market consolidated afterward. But, when the Fed backed off in September, it went on a tear again. When the Fed took its first step in December, it was viewed as too small to have an impact. The market has continued its rally. The S&P 500 rose by 30 percent in 2013. It remains to be seen if the Fed could prevent a rerun of 2000: the market surges in the first quarter of 2014 and falls sharply afterward.
China's stimulus, mainly through lowering the credit standard, led to a 175 percent increase in M2 from 2007 to 2013. The main growth consequences are a 61 percent increase in electricity production and an 82 percent increase in nominal dollar exports. While the growth data are still impressive, they are small in comparison to monetary growth. If such a relationship persists, hyperinflation is likely. Further, the growth numbers have come down in the past two years, while monetary growth has slowed less. The trend suggests that the effectiveness of monetary stimulus is declining. Hence, achieving the same growth target brings a higher inflation rate.
The growth dynamic in the past five years depends on local governments borrowing money to spend. The declining effectiveness of monetary growth reflects the same declining efficiency in local government expenditure. The growth dependency on local government spending is tied up with property speculation. As excessive monetary growth triggers inflation expectations, money has poured into land and property. As local governments control all the land supply, they have been able to raise revenues from selling land and borrowing money with land as collateral. These two are the main channels for money supply to turn into expenditure.
Neither China nor the United States has built a sustainable growth dynamic with stimulus. As the stimulus side effects – bubbles and rising leverage – become the main show unwinding stimulus becomes urgent. This is why both countries are likely to take tightening steps.
Smooth Tightening Is Rare
Unwinding stimulus is usually a dangerous business. One never knows how much hot air the stimulus has created. When it leaks, it could cause a big explosion. For example, the Fed's tightening cycle in the past usually triggered an emerging market crisis. As the United States itself isn't on a strong growth path, the risk at home is substantial.
I'm surprised by how weak the United States' growth has been, considering how much household wealth has risen. Hindsight suggests that the wealth increase is concentrated in a small minority who are too rich to spend all the gains. Before 2007 property inflation was driving household wealth, which benefited most people. As Wall Street created financial products for the masses to borrow against property appreciation, the economy benefited from a powerful wealth effect. The surging stock market has been driving household wealth in this cycle. As 10 percent of the United States' population own most of the stock, the wealth effect isn't broadly based. This is probably the main reason for the weak economic response to the stimulus.
Similar to the past, the Fed's tightening cycle could trigger another emerging market crisis. When the Fed mentioned that it could taper QE, emerging markets tumbled. Those with persistent current account deficits, like Brazil and India, saw a mini crash in their currencies. The hot money into emerging markets could be between US$ 3 trillion and US$ 4 trillion during the Fed's easing cycle. If a fraction of it returns, the shock to the monetary condition in some emerging economies could be severe enough to trigger a banking crisis. I suspect that several major emerging economies would have to raise interest rates aggressively to maintain financial stability. Otherwise, a currency-cum-banking crisis could happen.
The risk at home for the Fed is much higher than during the previous tightening cycles. The U.S. economy is still quite fragile. The improving labor market is due to declining wages for the reemployed. Hence, its contribution to demand is limited. The stock market could be 50 percent overvalued. The Internet sector is a vast bubble similar to what happened in early 2000. If the bubble pops, it may lead to reduction in corporate capex, which could pull the economy back into recession.
I have argued against the Fed's monetary policy on the grounds that globalization has short-circuited the feedback loop between demand and supply. Wages, for example, are determined by globalization, not the strength of local demand. What's happening to the U.S. labor market is similar to what happened to Japan and Taiwan in the 1990s. The economics behind the phenomenon are sound. What's unstable in the United States is that its stimulus policy has vastly inflated non-tradables like housing, health care and education, which makes internationally competitive wages insufficient for a minimum living standard. This could be the driver for stagflation in the United States. As labor demands a living wage, say, doubling minimum wage to US$ 15 per hour, the Fed may be forced to restart QE to counter its negative impact on labor demand, which leads to a price-wage spiral.
The Fed's tightening cycle this time is far from predictable, even though the Fed tries to project such an impression. If a financial crisis breaks out, either at home or among emerging markets, the Fed would be back to pumping liquidity to stabilize the market, which would be another step toward stagflation. If a labor movement at home depresses labor demand, it would be back to QE again, which also leads to stagflation. I predicted that stagflation is the ultimate outcome for the global economy. Most of the United States' nominal GDP increase since 2007 is due to inflation, which already fits the description of mild stagflation. If the Fed is forced to back off from tightening, more pronounced stagflation is not far off.
China's tightening is really about limiting local government borrowing. They are not interest rate sensitive. The current rise in interest rate is unlikely to dent their appetite. Indeed, China's local governments went to the shadow banking system for money at high interest rates in 2013, as banks have become wary of too much exposure to them. Local governments depend on the perception that provinces and, ultimately, the central government will bail them out, if they can't repay their loans. This is the reason that the shadow banking system is focusing on them. Private companies have been borrowing at low interest rates offshore and lending to them at high interest rate, either directly or through trust companies. Unless the bailout responsibility is clarified, China's credit bubble would continue.
If the central government spells out its position of no bailouts clearly and convincingly, the reaction in the credit market will likely be massive. The shadow banking system, for example, wouldn't roll over their loans. Unless the banks step in – probably forced by the government – a financial crisis is possible. If the banks do step in, it is actually a bailout by the central government, as it will be forced to bail them out if they go down. When moral hazard is the main reason for a credit boom, cooling it slowly is very difficult.
I have always argued that a hard landing would be a good thing for China. It flushes out all the financial excesses quickly and allows the economy to have a fresh start and soon. China's labor shortage ensures that such a landing wouldn't lead to social instability. Declining inflation would improve people's living standards. Hence, it's all good looking from the people's perspective. The banks and local governments wouldn't look at it that way. They all hope to stretch out the time horizon for paying off the legacy costs from the bubble. Or better that the people in charge now could walk away before the problems are exposed. Hence, the system's bias is to drag it out. But, a bubble grows larger if it doesn't burst. One cannot hold a bubble stable; it either shrinks or expands.
China is showing some resolve in reigning in the credit bubble. A credible anti-corruption campaign and rising interest rate are the visible signs. The tightening path is anything but assured. The system's bias for stable appearance may cause the policy to change direction.
Global Growth Tilts Down
The global economy has depended on stimulus in China and the United States since 2008. As they embark on tightening, one clear implication is that the global economy will slow in 2014. One obvious market implication is that commodity economies will see their currencies dropping again.
At the beginning of 2013, I predicted that Australian dollar, Indian rupee and Japanese yen will tumble, though for different reasons. In 2014, the Australian dollar will continue its tumbling. Other commodity currencies like Brazilian real, Canadian dollar, Russian ruble and South African rand will all come under pressure. The simple logic is that they are really driven by China's credit cycle. If China's credit cycle reverses, their currencies will lose their gains on the way up.
Hot money doesn't really go back to the United States per se. It just vanishes. When investors or speculators borrow dollars and buy local currency assets in emerging economies, the latter's central banks issue local currencies and use the dollars, now called foreign exchange reserves, to buy U.S. treasuries. The consequence is an expansion in the global balance sheet of assets and liabilities. When the hot money flow reverses, the global balance just shrinks. Such deleveraging hits hard any economy that depends on hot money to finance its persistent current account deficits. India stands out as an example. Its central bank, since its new governor came in, has surprised on the upside. It has been tightening ahead of the curve. India could avoid a financial crisis. The price is much slower growth or even a recession.
The Japanese yen is likely to be range bound. Japan's inflation has picked up. The Bank of Japan (BoJ) doesn't have an excuse to push down the yen further. If it does, the reaction from U.S. automakers would be severe. In the long run, the yen will continue to decline. But, this doesn't happen in a smooth curve. What the BoJ does is to concentrate the yen weakness in a short period, which gives the economy a lift. When the lift is exhausted, it pushes for another bout of yen weakness.
I believe that gold has already bottomed in 2013. In a Fed tightening cycle, gold tends to go down. Financial players in this cycle have been impatient to kick gold down as hard as possible. They short gold producers first and then gold. The gold stocks are much bigger in value than gold market per se. Hence, the trading strategy of shorting gold stocks and then gold could be lucrative. As more and more people pursue the same trade, the gold is kicked down way beyond its fundamentals.
Gold demand is from emerging economies. The latter have been experiencing high inflation. The demand for gold has been strong despite the weak gold price in 2013. The current gold price is already below the production cost of some of the biggest mines in the world. I suspect that, in 2014, some mines may be shut. The reduction in supply will become a counterforce against the Fed's tightening.
I want to repeat my long term bullish call on gold. Its price is likely to top US$ 3,000 in five years. The currency market instability and the likely global stagflation will strengthen gold demand for wealth preservation in emerging economies. As supply is unable to grow, the price has to rise to balance the market.