Can the bursting of Chinese bubble affect US long-term interest rates?

May 28th, 2007

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Back in What if the Chinese stock market bubble burst?, we mulled at the implications of a Chinese stock market crash. Today, we have some more thoughts on that.

There is absolutely no doubt that there is a stock market bubble right now in China. Sooner or later (more likely sooner), as it always happens to all bubbles, it will burst. There are some who speculated that the Chinese government would not allow the bubble to burst before the Beijing 2008 Olympics. Our question is, can the Chinese government really control the timing of the burst? Human greed knows no bounds and can never be controlled. Can any government, no matter how totalitarian or paternalistic, control the greed (and its twin, fear) that is inside the human heart?

Back in Analysing recent falls in oil prices?real vs investment demand, we put a distinction between the real side and the financial side of the economy. Our belief was that since the financial side of the Chinese economy is relatively less well developed and important compared to the real side, a financial market meltdown should not derail the long-term growth of China. We believe this is generally true in the very long run that is measured in terms of decades. But upon seeing the increasingly out of hand stock-market craze in China right now, we cannot help but feel that a stock market crash will have tangible consequences.

Right now, price inflation is a serious concern in China (see Why is China printing so much money?). Saving money in a Chinese bank will result in a loss because the interest that is earned will not cover price inflation. Therefore, in the eyes of many ordinary Chinese, the only way to get ahead of price inflation is to use the money to buy stocks. Recently, for the first time ever, the amount of savings in the banks fell below the total market capitalisation. Of even greater concern, there are reports of people using their homes and retirement savings as collaterals to punt in the stock market.

Thus, the longer the bubble expands, the more savings that will be ploughed into the asset price bubble. What will happen to all these savings if the stock market crashes? In that case, vast amount of Chinese middle-class wealth will be wiped out. In such a situation, Chinese domestic demand will surely contract suddenly, resulting in social instability. In addition, with the Chinese banking sector already having enough bad debt problems of its own, will such a scenario compound this problem when the retail stock speculators default en masse on their margin lending and collateral loans? It is not hard to imagine the possibility of a financial crisis in China, which can result in a ?hard? landing in China (a dramatic slowdown of growth to 4-5% is considered a ?hard? landing in China). Should a ?hard? landing occurs, what will happen to the hundreds of millions of workers who had migrated from the rural regions to work in the factories in the cities in search of a better life?

The Chinese government, who prize stability above everything else, will ensure that this will never happen. The only way out is to print money?to prop up the stock market or the banking sector to prevent a liquidity crisis. We can see that price inflation, which is already a serious concern, can get worse.

But there is another problem?the Chinese currency is still not a freely floating one. Printing money and cutting interest rates is devaluation on the currency?it is something the Chinese government is very well tempted to do. However, it is not possible to control the money supply, interest rates and fix the exchange rate simultaneously?you can control either one or the other but not both. With the protectionist mood getting ugly in the US, devaluation of the RMB will not tolerated by the US. What can the Chinese government do? In that case, the only choice left is for the Chinese central bank to liquidate the trillion US dollar reserves. What will be the outcome? See China unwilling to hoard US dollars?what?s the implication?.

We shudder to think of this.