April 21, 2004

Unsustainability

There is a battle going on that I bet you didn't know about. It is a battle of cliches: China boom (Google gives 828,000 hits) vs China bubble (452,000). Clearly the bubble has a way to go to catch up. But it is the clearest current threat to the emerging world economic recovery. America seems to be back on its feet, Europe is through the worst and even Japan may have finally kicked 12 years of depression and deflation. And they've all got China to thank. But will they be there for China when the shoe's on the other foot?

China has sucked in a huge amount of the world's exports to help continue its rapid expansion. China has been responsible for one quarter of all the world's economic growth in the past 5 years. And it is clearly unsustainable. People are getting worried, including the Chinese themselves.

The question becomes what can they do about it? And herein lies the problem. China is not a normal economy. Having a fixed exchange rate means they effectively have no monetary policy (ie control over interest rates). Or it would in a normal economy. But being China, they can direct banks to change their level of interest, so this tool still remains open. However credit isn't allocated on the basis of price in China (the price being interest rates). It is often allocated acording to political dictates. This means their banks have bad loans of 50% of assets (and potentially more) it isn't easy to raise rates. Even more so when much of state sector, still the largest part of China's economy, relies on easy credit to stay in business and to keep literally millions employed. The People's Bank have increased bank reserves thrice in a ayear to limit the free flow of credit but that hasn't helped. Nor has a central Government directive to basically stop lending to the sectors they consider to be overheating (steel, cars, cement, aluminium and property), yet.

Effectively China does not allocate it's capital efficiently. That means that deserving investments miss out while undeserving ones get loans; and it means savers get ripped off by low rates. To make matters worse the fixed exchange rate and large influx of foreign money means the People's Bank has to continually sell yuan to buy the foreign currency. This creates evermore liquidity, leading to an inflationary spiral. Hence the ongoing pressure on the fixed exchange rate and the inevitablity of a revaluation of the yuan. When that happens, suddenly China's demand for US Treasury bonds and dollars will drop and that will mean drops in prices of both. So for all the election year bashing of China in the US, in fact the US has never needed China so much as a source of cheap labour, a buyer of its dollars and bonds and a source of demand for US goods and services.

So the problem remains how does China combat an end to the bubble? The US faced this problem 4 years ago and solved it by dropping interest rates to historical lows, pumping liquidity, letting the dollar fall and allowing a rising property market (some would say new bubble) cushion the blow. None of that is available to China. The only solution is for them to revalue or perhaps even float their currency with potential to bring their banking system down instead. This a greater risk now given China's massive foreign exchange holdings which will be worth much less in local currency terms after a revaluation. Not to mention the large reserves transfered to the big banks in the past six months which was done in US dollars . Any revaluation reduces this new capital buffer, which hurts when you're carrying 50% of assets as bad loans already.

The end result. If you're having a sh!t day, just imagine how much worse it could be as a Chinese central banker of finance ministry official. At least you don't have 1.3 billion people depending on you to find an answer that doesn't exist.

UPDATE: There's a brief follow-up here.

Posted by Simon at April 21, 2004 05:15 PM | TrackBack
Comments

Great post Simon.

Posted by: Martyn at April 22, 2004 02:36 PM
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