China's undead growth

Something has been bothering your blogger for two months.

During early October's furious discussion of the end Bretton Woods II (BWII) and an accelerated global rebalancing, this blogger quoted Micheal Pettis:

Most probably Beijing will do the same thing Tokyo did after the Plaza Accords and Beijing did after the renminbi began appreciating in 2005. It will lower real interest rates and force credit expansion.

This of course will have the effect of unwinding the impact of the renminbi appreciation. As some Chinese manufacturers (in the tradable goods sector) lose competitiveness because of the rising renminbi, others (in the capital intensive sector) will regain it because of even lower financing costs. Jobs lost in one sector will be balanced with jobs gained in the other.

But there will be a hidden cost to this strategy – perhaps a huge one. The revaluing renminbi will shift income from exporters to households, as it should, but cheaper financing costs will shift income from households (who provide most of the country’s net savings) to the large companies that have access to bank credit. So China won’t really rebalance, because this requires a real and permanent increase in the household share of GDP. Instead what will happen is that it will reduce Chinese overdependence on exports and increase China’s even greater overdependence on investment.

This will not benefit China. It will fuel even more real estate, manufacturing and infrastructure overcapacity without having rebalanced consumption. Expect, for example, even more ships, steel, and chemicals in a world that really does not want any more.

Back then, your blogger added that:

In this scenario Australia becomes Ken Courtis' light bulb plugged into the Chinese nuclear reactor. Chinese fixed investment and use of steel surges as the real estate bubble enters a blowoff phase.

As the $US falls, global equity markets at last have a seemingly sustainable narrative for US economic growth around export demand and the Dow powers ahead.

Commodities enter a combined demand and monetary boom that makes 2008 look like a dress rehearsal. This may run for a couple of years and will look like an Australian Golden Age. But it ends in disaster as bad loans hobble Chinese banks when its bubble bursts and growth there slows permanently as it must grow through a balance-sheet recession. Even as tremendous new supply in commodities hits global markets.

The thorn that has been stuck in this bloggers mind ever since is that this scenario was couched as a future possibility based around an explicit breaking of BWII. This ignores the fact that BWII is already in part broken, despite the retention of currency pegs. It has been so since the the GFC.

BWII is the tacitly agreed system of a $US reserve currency kept strong by emerging markets that buy dollars to keep their own currencies weak. In effect, it's a kind of unofficial Marshall Plan in which the US consumes and runs deficits nobody else can, whilst emerging economies fast-track economic growth by exporting into the US market. The giant surpluses resulting from the currency pegs are then re-loaned to the US. The dynamics are particularly strong in the Chinese/US relationship.

Clearly these dynamics ultimately result in huge external imbalances for all involved. The GFC was the reckoning of those imbalances. Both deficits and surpluses dramatically contracted after the banks that mediated the saving of one into the debt of the other collapsed.

Although the currency pegs remain in place, the trade shock in China and the financial and unemployment shock in the US was the beginning of the end for BWII. The Chinese response to this was precisely the one outlined by Michael Pettis. It is not a future danger resulting from an overly quick appreciation of the renminbi, it's a clear and present danger in a raging credit bubble, as the chart above shows.

So where does that leave us?

China is busy trying to crimp credit growth with small moves here and there. But as Doug Noland wrote last week, the Chinese are on the horns of dilemma:

The bubbling Chinese economy faces its own issues. Entrenched Bubbles scoff at “tinkering” and timid policymaking – and China’s Mighty Credit Bubble is proving no exception. Today, China’s Politburo released a statement proclaiming that next year they “will adopt proactive fiscal policies and prudent monetary policy.” The country’s officials are increasingly aware that aggressive tightening is warranted. Home price inflation has proved resilient, while general consumer price inflation has become well-entrenched. Food price spikes have emerged as a serious problem.

When I read of Chinese policy moves intended to suppress Credit and financial flows going to speculative endeavors – while actively promoting lending to more productive enterprises and to ensure ongoing economic expansion – I am reminded of the failed course of U.S. monetary management in the latter years of the “Roaring Twenties.” It is the nature of Bubble economies that they become Credit gluttons. Credit growth and financial flows grow increasingly unwieldy – and the greater the inevitable imbalances the greater the overall Credit expansion required to sustain the boom. Efforts to sustain boom-time prosperity – while at the same time attempting to harness asset inflation and suppress increasingly destabilizing speculation – are prone to spectacular failure.

Chinese authorities recognize they have a problem – a serious monetary dilemma compounded and complicated by our QE2. Today’s Politburo statement adds further evidence that more aggressive tightening measures will commence in 2011. Yet the markets have turned numb to such warnings. And I’ll be the first to admit skepticism that the Chinese will administer the necessary harsh medicine. Chinese authorities have waited too long and allowed “terminal” Bubble excess to gain a powerful foothold. With the Fed and ECB kicking the can down the road, the markets can be forgiven for believing that Chinese policymakers will lack the fortitude to truly tighten system Credit and liquidity.

Noland's analysis is looking suddenly prescient given the Chinese aversion to raising interest rates on display overnight in the face of this spectacular chart from BS:



Yes, that's Chinese inflation on a charge. The result not only of credit expansion but an undead BWII. As Hugh Hendry put it recently:

As other interventionists have learned much to their chagrin, you can game the monetary system but you cannot beat it. China's insistence on undervaluing and managing its currency whilst capital flight to its shores pushes more freshly minted renminbi back into its expanding banking system is evidence of the international order seeking equalibrium if not through the external value of the renminbi then through higher domestic Chinese prices.

This blog has had long-term faith in the Chinese catch-up story. There is so much latent growth in emerging markets with cheap labour that embrace the capital intensity of free market policies. However, the undead status of BWII is already dramatically raising the stakes on Chinese growth and its nexus with credit.

Add to this the financialisation of commodities and we have the makings of a spectacular blow-off round of global growth that does indeed resemble an Australian Golden Age. Even as it marks the end point for Chinese uber-growth and the start of commodities oversupply.

P.S. This blogger is well aware that this scenario hinges upon a stabilising resolution to the European debt crisis. One almighty 'if'.