Posts Tagged ‘asset price bubble’

Hazard ahead for Australia- interim crash in China

Sunday, January 3rd, 2010

This is the first major post of 2010 (the previous post was more for our readers’ entertainment). Today, we will look ahead at a likely hazard facing Australia in 2010 and beyond- an interim crash in China.

First, you may wonder why we used the word “interim” before the word “crash?” To answer this question, you may recall what we wrote in June 2007 at Will the China boom go in a straight line?,

… one of the common stories we hear is this: since China is an ascendant superpower, its demand for commodities will increase in the decades to come, and hence, the commodities super-cycle will have a lot more room to go for a very long time.

However, the market always latches on to the generalities of a story and takes a simplistic projection of the story too far into the indefinite future. What do we mean by that? Put it simply, we do not believe that the rise of China will take on the path of a straight line. Instead, there will be ups and downs, booms and bust and progress and setbacks. Anytime when the path does not look like a straight line upwards and take a temporary dive, the market will flip to the other extreme of this story and project extreme pessimism into the indefinite future.

In other words, when we say that a “crash” is coming in China, we do not mean that China will collapse into a heap of total anarchy, civil war, foreign invasions, internal divisions by warlords, etc as in the first half of the 20th century. Instead, as we wrote before, such a “crash” will be a major setback in the bigger scheme of things.

In this new year, this is the theme that investors (especially the highly leveraged property speculators in Australia) should be watching out for. Australia is highly leveraged to the Chinese growth story, both in terms of financial leveraged (look at Australia’s debt level) and population leverage. The word “population leverage” will sound alien to you because this is a phrase that we invented in this article. To understand this phrase, consider this: the entire population of Australia can fit into population of just one major Chinese city (Shanghai) if you include the ‘unofficial’ migrant workers. Because of the colossal size of China, if every Chinese reduce their consumption by 1%, then its effect will be much more than 1% reduction in income on Australia. Therefore, investors should understand this basic principle: because of the leverage that Australia is exposed to China, any slowdown in China will have a leveraged effect on Australia.

The Panic of 2008 should be the year whereby a major correction in the Chinese economy could have occurred. Indeed, in late 2008, one newspaper headline in the Sydney Morning Herald was screaming of a great “stall” in the Chinese economy. Indeed, it seemed at that time that what we wrote in January 2008 at Can China really ?de-couple? from a US recession? was coming into fruition.

However, what stopped the major correction in the Chinese economy in its track was a massive government stimulus and ultra-loose monetary policy. The former is concentrated on fixed asset and infrastructure investments (e.g. construction boom, bridge building, etc), while the latter is basically force feeding loans into the economy (see How big is the credit bubble in China? and Is China setting itself up for a credit bust?).

The problem with these government policies is that, while it may have averted a major correction, the structural imbalances in the Chinese economy are being exacebated. To understand the gravity of this situation, consider this simplified line of thought:

  1. Prior to the GFC, the Chinese economy was highly geared towards capital investments in the form of productive capacity for exports.
  2. A contraction in demand in the US/Europe led to a disproportionate contraction in Chinese economic activity (see Can China really ?de-couple? from a US recession? to understand the theory behind this reasoning).
  3. Chinese economic activities that are related to exports suffered the worst of this contraction.
  4. Chinese government stimulus and ultra-loose monetary policies led to increased economic activity in the Chinese economy mostly in the area of capital investments for infrastructure.
  5. Overall the economy ‘grew’, but a lot of them are wasted and ‘leaked’ into mal-investments, asset market bubbles, corruption (see Will China succeed in navigating its way out of the Global Financial Crisis (GFC)? for a juicy story about corruption in China) and trophy projects.

You see the problem here?

Chinese government policies are accentuating the gap between investments in future productive capacity and current consumption of the Chinese people. To further complicate the picture, infrastructure investments produces capital goods (e.g. bridges, roads, highways) that cannot be exported. If Chinese consumption cannot grow fast enough to catch up with huge expansion in productive capacity and American consumption cannot recover enough to fill the gap, then what will happen to those investments?

Obviously, these investments will, at best result in a dismal return and at worst, result in bad debts. And we know bad debts are the roots of a credit crisis.

We believe consumption growth cannot catch up fast enough. As we wrote in Can China really ?de-couple? from a US recession?,

  1. The needs of the Chinese consumption economy is different from the US consumption economy. Some Chinese are rich. But some other parts of China are unbelievably poor. Wealth distribution in China is rather uneven and there are still many pressing social and environmental issues to be solved. Currently, the Chinese export economy is tooled towards US consumption. To re-tool and re-configure the Chinese economy towards its domestic needs requires a period of adjustment in which capitals are destroyed and built. As we said before in Overproduction or mis-configuration of production?, the issue is not a simple case of overproduction. Rather, it is the mis-configuration of production that is the issue.

Because of the structural imbalance between consumption and investments, a lot of these forced investments are leaked into asset speculation (e.g. look at the massive property bubble in Shanghai alone). To understand this point, consider what we wrote in Connecting monetary inflation with speculation,

Thus, by further inflating the supply of money and credit in the financial system at such a time, there comes a situation whereby there are excess liquidity without adequate avenues for appropriate investments.

The ultra-loose monetary policies in China resulted in too much money and credit sloshing around in the financial system. The structurally weak and mis-configured domestic consumption market means that there’s not enough avenue for appropriate investments. Hence, a lot of money and credit ended up as speculations in the asset market.

To structurally streghthen the Chinese domestic consumption market, the gap between the rich and poor has to be narrowed. Anecdotal indications suggest that the opposite is happening, thanks to inflation (see Does monetary inflation increase the rich-poor divide?). The bubble in the asset markets is worsening the situation.

By now, you should be able to appreciate the gravity of the situation. The ‘success’ of the Chinese government seems to have averted a major economic correction. But in reality, they are just postponing it for a greater bust in the future.

What is the implication of this in the financial markets? Keep in tune!

Government taking tougher line on debt and bubbles

Tuesday, July 28th, 2009

To be a successful investor, one must be be aware of the sea-changes that are happening in the economy and financial markets. One of the sea-changes is in the line of central bank thinking. As we wrote in How are central bankers going to deal with asset bubbles?, central bankers are now more ready to deal with asset price bubbles than before. Previously, central bankers were targeting price inflation rate with their monetary policy while they stood idly by to let house prices form a bubble. As Glenn Stevens, governor of the RBA said today as reported in this mainstream news article,

Not only would it confirm that there are serious supply-side impediments to producing one of the things that previous generations of Australians have taken for granted, namely affordable shelter, it would also pose elevated risks of problems of over-leverage and asset price deflation down the track.

Please note that we are not endorsing the economic literacy level of that news article. Rather, we are quoting Glenn Stevens to show you what is going on inside his mind. The RBA is also hinting repeatedly that the next move in interest rates is up. Basically, the RBA is telling Australians this: you better wake up from your old ways and get serious about repaying your debts because the party is over.

This line of thinking is in sharp contrast to China’s central bankers, who are allowing a debt bubble to grow (see Is China setting itself up for a credit bust?) and spill over into asset prices (e.g. property and stocks).

The next sea-change is the change in the line of thinking from our dear Prime Minister, Kevin Rudd. He wrote in his essay published a few days ago,

The roots of the crisis lie in the preceding decade of excess. In it the world enjoyed an extraordinary boom… However, as we later learnt, the global boom was built in large part on a three-layered house of cards.

First, in many Western countries the boom was created on a pile of debt held by consumers, corporations and some governments. As the global financier George Soros put it: ?For 25 years [the West] has been consuming more than we have been producing … living beyond our means.”

Second, these debts were racked up on the back of sky-rocketing asset prices. In several countries, stock prices and house values soared far above their true long-term worth, creating paper wealth that millions of households used as collateral for their growing debts.

This crisis has shown we have reached the limits of a purely debt-fuelled global growth strategy. Not only will the neo-liberal model of the past not provide growth for the future, its after-effects will make recovery more difficult. Mountains of global public and private debt, global imbalances, and a weakened global financial system will drag on global growth for a long time. As the renowned financial columnist Martin Wolf has written: “Those who expect a swift return to the business-as-usual of 2006 are fantasists. A slow and difficult recovery, dominated by de-leveraging and deflationary risks, is the most likely prospect.

This had been what we were arguing for a few years already (see Aussie household debt not as bad as it seems? on January 2008 and The Bubble Economy in October 2006). Kevin Rudd has finally understood the root cause of the GFC- spendthrift ways financed by rising debt using bubbly asset prices as collaterals. Now, he acknowledges that de-leveraging (repayment of debts) will be the fashion for a long time, in contrast to the past few decades of increasing debts. For many Generation Xs and Ys, the change from profligate to more frugal ways will be alien to them.

Unfortunately, as the mainstream always do, both the RBA and government is one-step behind.

The global economy is like a heart-attack patient on a life-support system. He faced a near-death experience in the second half of last year. Today, his condition has stabilised. But it will be a long time before he will fully recover and be fit enough to run again as in 2007. What the government is doing today is to inject more steroids (targeted stimulus spending financed by public debt) in the hope to see the patient running as soon as possible. The result is a walking zombie on life-support system (massive liquidity injections via ‘printing’ money).

As we wrote in Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view, the government is in danger of painting itself into a corner with no exit strategy (even though they’re talking a lot about it). If the exit strategy fails, we know the result is very high inflation (maybe even hyper-inflation).