Andy Xie: Here We Go Again

Former Morgan Stanley Analyst Andy Xie explains why China is a potential bubble:


Asset bubbles come and go. Each begins with a story: Japan as No. 1, the East Asian miracle, dotcom mania, how financial innovations eliminate risk – just to mention the latest four. Each begins with a plausibly bullish story, which is then magnified by the financial markets, creating the inevitable bubble.

Back in the 1980s, Japan produced world-conquering, seemingly invincible companies like Sony and Toyota. Their competitive gains justified the re-rating of Japan’s asset prices. The issue was by how much? This is where imagination ran riot. Next came the East Asian miracle – a story of gross domestic product. The “Asian Tiger” economies generated high GDP growth rates even while the US economy was depressed. Financial markets caught on to that, extrapolated the trend ad infinitum, and re-priced their assets accordingly.

At the end of the 1990s, the dotcom phenomenon conjured up the possibility of making unlimited amounts of money in a new economy. Financial markets ignored the role of competition in limiting profitability, while irrational exuberance led to overinvestment and the collapse of profitability. More recently, financial innovations were peddled with a tale of decreased risk through financial engineering, and that lower risks would lead to the re-rating of risk assets like property or stock. It turned out that this, too, was just a story. Decreasing risk was a mathematical illusion. As more and more people believed the story, prices of risky assets moved higher, which validated the expectation of lower risk – for the time being.

The current bubble is unique. It began with a horror story: paper money will evaporate in value and, hence, you should buy something — anything — with it. At a recent lecture I gave in Hangzhou, one wealthy member of the audience said: “Property may be 100% overvalued. But I will still get half when it comes down. Paper money will be worth zero.” The allure of this latest tale is that the economy doesn’t matter. If the world is in recession, so what? If stock and property markets collapse, so what? We just run away from paper money, right? Better to borrow to buy assets. This is where bank lending policies come into play. But the more willing the banks are to lend, the hotter the asset markets become.

Chinese mainland banks experienced a banking crisis a decade ago. They lent with abandon for land speculation in the early 1990s, which led to rampant inflation and triggered monetary tightening. Land prices began to fall in the mid-1990s, and they sank further in the Asian Financial Crisis of 1997 due to falling exports. Forty percent of all bank loans were non-performing.

To rescue the banks, the government stripped out their bad assets, mandated wide lending margins to enable them to earn their way back, and floated them in Hong Kong for recapitalization. These helpful measures were accompanied by a lending boom after 2004. Now they are ranked first, second and third worldwide in terms of market capitalization.
However, for banks, good fortune doesn’t usually last. A lending boom is inevitably followed by a crisis. This has yet to play out on the Chinese mainland.

Right now, banks are force-feeding the economy with liquidity. The purpose of the so-called “quantitative easing” was to generate domestic demand while exports slumped, but the liquidity has flowed into property and stock markets instead (and has partly become government fiscal revenue).

The inflation-fear bubble will burst in due course. Paper money loses value over time at the rate of the difference between inflation and interest rates, so if the inflation rate is 6% and the bank deposit rate is 2%, paper money loses 4% per annum, or 0.33% per month. Stocks and properties in China may be 100% overvalued, with only two decades of relatively high inflation justifying their prices. However, persistently high inflation leads to currency devaluation, which triggers capital flight and, eventually, an asset market collapse. This story simply won’t hold together for long.

A case in point is the US Savings and Loans crisis of the late 1980s and early 1990s. The US Federal Reserve kept monetary policy loose to help the banking system. The dollar went into a prolonged bear market. During the descent, Asian economies that pegged their currencies to the dollar could increase money supply and lending without worrying about devaluation, but the money couldn’t leave home due to the dollar’s poor outlook, so it went into asset markets.

When the dollar began to rebound in 1996, Asian economies came under tightening pressure that burst their asset bubbles.

The collapsing asset prices triggered capital outflows that reinforced asset deflation. Asset deflation destroyed their banking systems. In short, the US banking crisis created the environment for a credit boom in Asia. When US banks recovered, Asian banks collapsed.

Is China heading down the same path? There are many anecdotes to support the comparison. Property prices in Southeast Asia became higher than those in the US, but “experts” and government officials had stories to explain it, even though their per capita income was one-tenth that of the US. Their banks also commanded huge market capitalizations, as financial markets extended their growth ad infinitum. The same thing is happening in China today.

When something seems too good to be true, it is. World trade — the engine of global growth — has collapsed. Employment is still contracting throughout the world. There are no realistic scenarios for the global economy to regain high and sustainable growth.

China is an export-driven economy. Bank lending can support the economy for a short time, however, stocks are as expensive as during the heydays of the last bubble. Like all previous bubbles, this one, too, will burst.


Here We Go Again
Andy Xie
China International Business, October 10, 2009

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