Pumped With Cash – And Ready to Crash?

Former Morgan Stanley Analyst Andy Xie explains how Domestic and foreign money is pouring into Chinese real estate, not productive assets, as inflation risks rise and a new crisis brews:


Domestic and foreign money is pouring into Chinese real estate, not productive assets, as inflation risks rise and a new crisis brews

China’s foreign exchange reserves soared by US$ 453 billion in 2009, or 10 percent of 2008 GDP. Bank lending increased 32 percent to 9.6 trillion yuan. And yet nominal GDP rose only about 5 percent.

Clearly, the financial side drove China’s GDP growth last year, reflecting a new reality of the post-financial crisis world. But all that money produced relatively little GDP growth because it worked its way into a single sector: property.

Two market beliefs animate this continuing movement. First is the belief that China’s currency will only appreciate. The other is that China’s land prices will drive money flows.

The currency argument is based on cross-border capital flows. Capital inflow — not trade surplus, which fell by one-fourth from 2008 – drove China’s foreign exchange reserves in 2009. One data point was a surge in reserves before U.S. President Barack Obama’s China visit last November. Many hedge funds were positioned for yuan appreciation during the visit. When expectations were disappointed, the flow slowed. Slower growth for reserves in December supported this observation.

The second belief exerts a powerful effect on domestic capital flows. New property sales rose 75 percent year-on-year and topped 14 percent of real GDP in 2009 – a first for China or any major economy. Household savings were between 20 and 25 percent of GDP. It is easy to tell from property sales data where household savings are going.

On the business side, there has been an equally major shift in capital deployment. A proliferation of land barons – tycoons who broke all records at 2009 land auctions – showed where business investment was heading. Their eagerness for land hoarding was illustrated by an unusual yet widespread phenomenon: In any given area, land costs exceeded prices for existing developed property. This is why I suspect most bank lending last year was related to property.

Each belief depends on the key assumption that the Chinese government will let neither exchange rates nor land prices fall. The market psychology that the Chinese government is capping the downside for speculators has emboldened them to speculate in any asset class with a China angle.

Yet the assumption has not been tested because the U.S. Federal Reserve’s low interest rate policy continues to drive money out of dollars and into China-related assets. When inflation forces the Fed to raise interest rates quickly, probably in 2012, this assumption will be tested. In the current speculative game around China, the force is the Fed’s zero interest rate. When that changes, I suspect few of today’s speculators will be around.

Inflation’s Role
Inflation is playing into the game as well. The 23 percentage point difference between nominal GDP and growth in the money supply M2 last year has stored up a great deal of inflation for the future. The money is temporarily trapped in property and shows up as property inflation, but it is working into inflation through rising distribution costs.

Money supply cannot grow faster than GDP forever. A prolonged gap between the two usually suggests an asset bubble, i.e. excess money supply is piling up in an asset market. But sustained asset inflation inevitably leads to consumer price inflation, either through the wealth effect on consumption or a cost push on the production side.

It’s interesting that made-in-China products are priced higher at Chinese stores than in many other countries. High property costs are probably the most important factor. The same phenomenon occurred in Japan during the 1980s when Japanese goods sold for much more at home than in the United States.

The money supply surge is also working into inflation through expectation. When workers consider wage offers, property prices are probably their most important consideration. Incipient wage inflation could partly be explained by the devaluation effect of property inflation on money.
As far as I can tell, China’s consumer inflation rate is already quite high. India and Russia have stronger currencies than China’s and are experiencing nearly double-digit inflation. However, China’s official statistics still report low inflation. The discrepancy may be due to how inflation is measured.
The monetary surge occurred at a time when the economy is increasingly prone to inflation. Money printing eventually turns into inflation, although the transformation’s speed depends on many factors. The more plentiful the production factors, the longer the lag between money growth and inflation.

Between the mid-1990s and around 2005, China’s labor costs stagnated, even though labor productivity rose about 8 percent per annum. It was the biggest force keeping down domestic and global inflation. But recent years have seen a turning point for blue-collar labor: Wages have had to rise to attract workers. This change cut the lag between money creation and inflation.
Contributing to this change is a modern expansion of China’s college system, which substantially cut the blue collar labor supply. The current college student population is equivalent to three years of labor supply. Moreover, graduates who join the workforce don’t consider blue collar jobs. So the wage gap between blue and white collar jobs has sharply narrowed.

In addition, the labor overhang from the state-owned enterprise restructuring a decade ago is gone. Most of these workers have permanently dropped out of the workforce.

Blue collar wages are the second most important cost driver in manufacturing after raw materials, and in services after property. Raw material prices have an upward bias in the current environment, with low interest rates driving funds into most commodities as inflation hedges. Natural resources and production are competing for financing. I suspect prices for oil, copper and other resources will continue to rise in 2010.

China’s monetary overhang in a more inflation prone environment augurs poorly for the inflation dynamic this year and beyond. The growth outlook, on the other hand, is dimmer. On the demand side, developed economies will continue to suffer high unemployment and property deflation. Despite a strong export showing in December, China’s exports are unlikely to grow as they did in the previous five years. I expect China’s exports will average single digit growth for the next five years, compared to 27 percent between 2003 and ’08. Since the export sector roughly accounts for one-fifth to one-fourth of value-added GDP, the export deceleration could decrease overall demand growth by four percentage points or more.

On the supply side, the current redistribution of capital from manufacturing to property will substantially cut productivity growth rates. Property isn’t a productive asset. It is always very difficult to estimate the productivity growth rate, especially total factor productivity (TFP) which measures how much more output is produced from the same amount of inputs. My rough estimate of China’s TFP three years ago was 4 percent. As property doesn’t lead to meaningful productivity growth, if half the productivity capital is reallocated to the property sector, it is likely to cut the productivity growth rate by half as well. I suspect China’s total factor productivity will grow 2 percent rather than 4 percent in coming years.

These supply and demand changes necessitate tighter restraint on monetary growth. But that may not happen. Many analysts think slower economic growth requires more monetary stimulus. This is the wrong medicine; stimulus is not an easy way out, since its consequences are not immediately felt. But it does reap short-term benefits such as asset inflation, which is why vested interests support such policy moves. Thus, new stimulus measures stand a good chance of winning approval, even though this bad medicine will trigger sustained high inflation without stimulating growth.

China’s interest rate is probably three percentage points below what it should be to prevent inflation. But I don’t see any rate-raising policy action of such magnitude for the foreseeable future. When the People’s Bank of China recently made its first significant tightening, the move was tiny. Its half-percent increase in the deposit reserve ratio cannot significantly impact the lending capacity of a banking system with a 67 percent loan-deposit ratio. The system is short of capital, not liquidity; increasing capital requirements would have been more effective.
What China also needs is to increase consumption’s share in GDP to offset the export slowdown. That requires shrinking the size of investment, which is mostly government-led and equivalent to decreasing the government’s power for raising and spending money. Without significant structural reforms, such as changing local government incentives, raising consumption levels while shrinking investment will be very difficult to achieve.

As far as I can tell, China could experience a few years of inflation rates that are higher than GDP growth rates. It may not qualify strictly as stagflation. India and Russia, for example, are experiencing inflation rates that are much higher than their GDP growth rates. Both economies are still functioning. But such a scenario is best avoided, since it constrains policy maneuvering. China would need more wiggle room for stimulus in the event of a new shock, such as another global financial crisis.

Indeed, 2012 is building up to be another crisis year. Governments and central banks did not handle the last crisis well. They did not reform a global financial system plagued by incentive misalignment and wild speculation. All the money governments and central banks released is turning into global inflation. And they resorted to bailing out speculators, laying the foundation for another crisis.

Full Article in Chinese: http://magazine.caing.com/2010-01-24/100110562.html

Pumped With Cash – And Ready to Crash?
Andy Xie
01.27.2010 19:11

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