㰀䴀䔀吀䄀 渀愀洀攀㴀䜀䔀一䔀刀䄀吀伀刀 挀漀渀琀攀渀琀㴀∀䴀匀䠀吀䴀䰀 㠀⸀ ⸀㘀 ⸀㤀 㤀∀㸀㰀⼀䠀䔀䄀䐀㸀
Making room for China
Commentary and weekly watch by Doug Noland
Foreign exchange reserves held by the People's Bank of China surpassed US$3.0 trillion in March - not shabby for holdings that began year-2000 at $155 million. China's international reserves surpassed $1.0 trillion for the first time in October 2006 and jumped past $2.0 trillion during April 2009. Reserves expanded $590 billion over the past nine months, a 28% annualized pace. This unprecedented growth is even more noteworthy considering the rapid shrinking of China's trade surpluses. Indeed, Q1's near record $197 billion increase in reserves compares to a trade surplus for the period of $13 billion (smallest surplus in seven years).
When it comes to bubble analysis, the stunning expansion of Treasury debt and Federal Reserve credit offers an easy target. Yet I've posited for two years now the emergence of something quite more expansive - a "global government finance bubble". The key dynamics involve an extraordinary expansion of government borrowings and central bank balance sheets around the world - developed and "emerging". I have argued that China is in the midst of "terminal phase" of credit bubble excess, a circumstance that has created powerful financial and economic interplays with respective US and global bubbles.
The current environment could not be more fascinating from the standpoint of analyzing credit and bubble dynamics. Most everyone is dismissive of the notion of some new bubble, in the US or elsewhere. Few are willing to see anything resembling huge excess or market distortions. Meanwhile, charts of Treasury debt, the Fed's assets, and Chinese reserve holdings confirm that something unique in the history of finance is unfolding right before our eyes.
It's worth a brief review of the week's economic data out of China. At 9.7%, first quarter Chinese growth was stronger-than-expected - and the fastest pace of expansion since 2008. March exports were up 35.8% y-o-y, outpacing imports that expanded 27.3%. Also above consensus forecasts, industrial production advanced 14.8% and retail sales jumped a brisk 17.4%. The value of first quarter home sales increased a notable 26% from the year-ago period. New home construction was up 20% during the quarter. It all points to another record year of credit growth.
There is not yet much to show for Chinese government efforts to impose some monetary restraint. March bank lending increased to $104 billion, 16% ahead of estimates. At almost $380 billion, first quarter bank lending was significantly above target. March M2 money supply growth of 16.6% was also above estimates. In its warning this week on Chinese debt, Fitch noted that loans to the Chinese corporate and household sectors last year jumped to 140% of GDP, up from 111% back in 2008. At 5.4%, March year-over-year consumer price inflation was the highest since 2008, with food inflation jumping to 11.7%. And while on the subject of inflation, consumer prices have been rising at an almost 9% pace in India.
It is a tenet of credit bubble analysis that bubbles over time become progressively impervious to government tightening measures. A key facet of a bubble's "terminal" phase is that only aggressive intervention will work to restrain broadening lending, speculating, and spending excesses. Excess begets excess. Meanwhile, the perception of escalating risks associated with intervention virtually ensures policymaker timidity. This remains my expected course for China.
China has clearly reached the point where it plays a critical role as marginal buyer of global energy, commodities and, increasingly, goods and services, while at the same time operating as a key source of liquidity for global financial markets. Central to the global bubble thesis is that government stimulus from Washington to Beijing has boosted growth, while also profoundly impacting marketplace liquidity, global financial flows and the perception of risk throughout the markets. The global liquidity backdrop is increasingly a serious problem for China, and Chinese inflation is a growing issue for the world.
The weak dollar, in particular, has been critical to the unleashing of credit and speculation excess throughout the so-called "emerging markets." China and the other BRIC countries - Brazil, Russia and India - continue to operate in a highly unusual environment of rampant credit growth and mounting imbalances, while at the same time enjoying rock solid currencies relative to the soft dollar. The second, continuing, round of quantitative easing by the US Federal Reserve (QE2) incited a whirlwind of "hot money" flows out to various "undollar" destinations, including energy and commodities, the emerging economies and China.
And the incredible growth in Chinese international reserves is confirmation of the scope of today's global "hot money" flows. It is worth noting that Chinese reserve growth had slowed markedly in 2010, before accelerating rapidly after the Fed's decision to proceed with another round of quantitative easing.
The Fed is keen to absolve its rate policy and "QE2" as responsible for surging energy and commodities prices - pointing instead to robust Chinese and the developing world demand. I would be curious to hear how they see zero rates and quantitative easing as having impacted the dollar, as well as what role the weak dollar has played on global speculation and financial flows. Do they see a connection between their monetization of Treasury debt, resurgent speculative trading and asset inflation, enormous "hot money" flows, the rapid expand expansion of Chinese reserve holdings, and the "recycling" of these dollar balances right back to the Treasury market? Are they oblivious to the self-reinforcing nature of these monetary processes - to such bubble dynamics?
Pronouncements from last week's meeting of the BRICS countries (South Africa being included in meetings for the first time) made it rather clear where they stand: "Excessive volatility in commodity prices, particularly those for food and energy, poses new risks ... " "We call for more attention to the risks of massive cross-border capital flows now faced by the emerging economies." BRICS leaders are calling for more regulation of derivatives markets. They also seek a modified global monetary system with a reduced role for the dollar and less dictated by US and developed world monetary policies. And one of these days they may actually impose their will.
Curiously, some leading analysts have become more sanguine on China. Talk has shifted from the risk of a bursting bubble to confidence in a "soft landing" scenario. Astute Chinese policymakers are thought to have tools to sustain strong growth, while ensuring that inflation doesn't get out of hand. With an overheated credit system and strong inflationary biases percolating throughout China's economy and asset markets, few tools will be required to sustain their expansion in the short-term. In the intermediate term, the incredible hoard of international reserves would seem to provide sufficient resources to recapitalize an increasingly susceptible banking system a few times over.
I still buy into the Chinese growth story. But count me skeptical on their capacity to manage an increasingly complex inflation problem. It is today unclear that they are succeeding in attempts to slow rapid bank lending. At the same time, they confront massive inbound financial flows. I am not convinced that they have a handle on the myriad sources of non-bank credit expansion (domestic and international) impacting their economy and various price levels. The overall financial environment remains too loose, yet aggressive rate hikes would lead to only more destabilizing "hot money" inflows.
Chinese authorities have apparently achieved success in reducing trade imbalances. One could argue that they are meeting the global call to boost consumption, a least partially accomplished through the rapid inflation in wages and incomes. Indeed, the historic inflation of system credit, incomes, corporate cash flows, asset prices, and household net worth greatly surpasses even the Japanese bubble experience. And, increasingly, this enormous expansion in purchasing power is stoking inflationary pressures at home and abroad - and risks an inflationary wage-price spiral.
Pimco's Mohammed El-Erian, while espousing a bullish view on China, suggested that there was a potential issue with the "world making room" for China. This is a good way of thinking about it.
Until recently, the ultra-loose liquidity backdrop ensured that China (and others) invested enormous amounts in manufacturing capacity. Despite global credit bubble excesses, price pressures were mainly relegated to securities and real estate prices. Many argued that China - and the emerging economies - were "exporting deflation". There are indications that the nature of inflationary forces is changing.
I am of the view that we have likely passed a tipping point where China and the "emerging" economies now exert increasingly strong inflationary pressures upon the global economy. Rapidly growing developing world incomes would tend to support elevated energy and commodities prices, while ensuring an upward inflationary bias in much that is produced globally. The cheap wages and low cost structures that combined with cheap finance to ensure seemingly endless goods seem to have run their course. It is worth noting that US March import prices were up 9.7% y-o-y, with producer price inflation trailing somewhat at 5.8%.
The Fed sees things altogether differently, clinging to the notion that the recent jump in energy and commodities prices will have only a "transitory" impact on inflation. They view "inflation" through a myopic focus on "core CPI" - and just don't discern much having changed in the world. But when I examine global price pressures, I see important dynamics that have been years in the making. The confluence of a persistently weak dollar, booming real and speculative demand for commodities, massive "hot money" flows, and rapid credit and wage growth throughout the increasingly powerful "developing" world is in the process of fundamentally altering global price structures. Meanwhile, developed world structural debt problems and vulnerable recoveries ensure unrelenting monetary looseness.
Yield charts for Greek, Irish and Portuguese debt suggest that the world is neither oblivious to structural debt problems nor the difficulties in trying to rectify them. At the same time, expectations for ongoing near-zero Fed funds place a low ceiling on Treasury (and related) yields. I would argue that a heavily distorted "bubble" market for determining US Treasury yields disregards risks associated with US structural debt problems and a rapidly deteriorating inflation backdrop. One of these days, China and fellow BRICS nations may arrive at the conclusion that the best hope they have for reining in "hot money," surging commodities prices, and increasingly unwieldy inflation is to back away from supporting our debt markets