Monday, April 23, 2012

High on property

Andy Xie warns that Hong Kong's dependence on the housing sector to drive economic growth is feeding another asset bubble. When it bursts, he says, the government should resolve to kick the addiction

Andy Xie

April 23, 2012

Hong Kong did not learn from the property crash and economic collapse of 1998. Instead, it has tried hard to reinflate the bubble. After squeezing supply for over a decade and with the help of the US Federal Reserve's zero interest rate, the bubble is back. But it is a Pyrrhic victory.

Hong Kong's economy is suffering. Between 1997 and 2011, nominal gross domestic product grew by 2.6per cent, per capita income by 2per cent, and the average salary by nearly 2per cent every year. Over the same period, the cost of living shot up - oil prices quintupled and food prices doubled - while China's labour costs tripled. It's easy to see why Hong Kong people are not happy.

More damaging is how concentrated in property and finance the Hong Kong economy has become. In 1997, aside from the property bubble, Hong Kong was leading the Pearl River Delta's industrialisation with the attendant high-valued-added activities such as research and development, trade finance and marketing based in Hong Kong.

But the high cost of doing business due to high property prices and rent has pushed away such businesses. The only new business that has helped Hong Kong is retailing to mainland tourists. But selling European products to Chinese tourists is a low-value-added business. Only landlords benefit significantly from it.

The social cost of squeezing supply to support a high price could precipitate social turmoil. While Hong Kong is considered a high-income economy, numerous families, many with members of three generations, live in one room. More than two-thirds of Hong Kong's land is undeveloped. And reclamation, the main source of new land for Singapore, has potential in Hong Kong. So, while popular perception attributes high property prices to a land shortage, it is utterly untrue. Hong Kong's elite fuels this misperception because they want to keep people in the dark.

Despite its gross mismanagement, Hong Kong hasn't collapsed because it can suck juice out of China. Hong Kong's prosperity depends on arbitrage opportunities arising from the mainland's inefficiencies. As the mainland becomes more efficient, such opportunities will become scarcer.

Mainland prosperity has also created a new business for Hong Kong - monetising China's political power offshore. This round of Hong Kong's asset boom has much to do with this force. That business, however, won't last, either. China's political reforms will come sooner than expected.

No great city can thrive just on dodgy businesses like property speculation, arbitrage exploiting someone else's loopholes, or helping powerful people rob their countries. True, such businesses also exist in London and New York. But those cities have diversified activities to provide a decent living for the local populations, even as the elite profit from the dodgy activities. If Hong Kong's economy is to thrive, it must make Hong Kong people competitive.

After the 1998 collapse, the Hong Kong government took to setting a minimum price for land auctions. As the government is the only land supplier, it caused the economy to restructure around the government-mandated land price. Economic activities that compete globally couldn't survive in such an environment and decamped as a result. On the other hand, Hong Kong's Cantonese education has produced a generation ill suited for economic activities related to serving mainlanders' needs, dodgy or otherwise.

Hong Kong's economic winners and losers are determined by a game of when one buys a property. This game redistributes income; it doesn't make the pie bigger. Because land supply is controlled, downstream activities are just ripples in a river where the water level is fixed. Hong Kong's market economy, while often touted as laissez-faire, is not really market oriented.

Unless Hong Kong cuts property from its economic centre, it doesn't have a good future. Property isn't a productive asset. It is worth money only because the people who use properties are competitive. When policy squeezes up property prices by restricting supply, it just prices more and more people out of the modern economy. As their numbers accumulate, discontent will grow.

Hong Kong must control land supply according to its development needs, not to set prices. The city should first set targets for the size of its population and housing conditions - say, a minimum living space of 200 square feet per person - and land supply should follow. The current property bubble will eventually burst, like the ones before, when the US Fed raises the interest rate. And when it does, the government must resist manipulating supply to support prices. It should be viewed as an opportunity to restructure the economy.

To control the damage from a property crash, the government should tighten prudential regulations on the banking system. Hong Kong has an unusual capital accounting requirement for mortgage lending. At 8per cent of the standard capital requirement for lending, Hong Kong banks essentially need no capital for mortgage lending. This is why Hong Kong's mortgage interest rate is so low.

Hong Kong's banking system is a massive volatility amplifier for the property market. It may be good for developers, but it's not good for the economy. Raising the requirement to 50per cent, as it stands in mainland China, is a step that the government can take immediately to strengthen the economy.

Andy Xie is an independent economist

Thursday, February 9, 2012

Beyond the bubble

February 7, 2012 / Andy Xie

Andy Xie urges the Chinese government to embrace the restructuring that is needed to sustain economic growth, instead of using its financial muscle merely to delay the inevitable - a painful transition

China's obsession with stability may lead to greater instability. A skilful person can keep a ball on a bigger ball only for so long. China's economy faces serious structural problems. Reshuffling liquidity to keep everything afloat for now will lead to a collapse later. The right way forward is to accept restructuring, deal with the pain, and be reborn into a more dynamic economy. This way, China could become the world's largest economy in 10 years.

China has experienced a tremendous economic boom, the result of it joining the World Trade Organisation, its demographic dividends, and its building of infrastructural networks. China's nominal gross domestic product has almost quadrupled over the past decade to an estimated 47 trillion yuan (HK$58 trillion) last year, with exports up more than seven times in US dollar terms, while electricity consumption, the best proxy for real growth, is up by over 200 per cent. Prosperity on such a vast scale has never occurred before. China should be proud of its achievement.

Amid the prosperity, two related forces have been sapping China's dynamism: the rise of the state sector and a vast financial bubble. Fixed-asset investment, dominated by government and state enterprises, rose from 2.8 trillion yuan to 31 trillion yuan, or from 30 per cent to 65 per cent of GDP, over the past decade. It is a symbol of the nationalisation of demand during the boom. Its two consequences are rising corruption and declining efficiency. The bubble, especially in property, has diverted the energy of businesses and households towards speculation to chase quick profits. Amid rising costs, China's businesses have tried to stay alive through speculation rather than by increasing efficiency and upgrading products.

China's bubble isn't a result of investors overreaching. In this system, every bubble-making opportunity is seized upon because it benefits the government and the people with influence. The productivity gains from joining the WTO, the demographic dividend and infrastructural build-up should go into raising profits and real wages. But, through rampant monetary expansion and government manipulation of the land market, the productivity gains have gone into supporting a giant credit-cum-land bubble.

The bubble has begun to deflate. Many blame the government's tightening measures, but they have merely brought forward the inevitable, because the bubble was already unsustainable. The WTO dividend is gone. The depressed global economy is turning China's export dependence into a weakness. Population ageing is causing labour shortages, shifting money from asset inflation to price inflation. And, the quantum benefits from building infrastructure have mostly been absorbed.

The right way forward is to: first, quickly deal with the bad debts from the bubble bursting; second, rebalance demand from the government to the people through tax cuts; and, third, to boost supply-side efficiency through industrial consolidation.

China's banking system has 110 trillion yuan in total assets or 234 per cent of GDP. While the reported loans are about half of those assets, a majority of the assets are loans to local governments and businesses, directly and indirectly. Much of the lending to businesses is also outside the banking system. And we know that most loans in mainland China go into property. China's property and land prices are likely to plummet from the peaks. Yet many more properties are under construction. China's bad debts could easily go into trillions of yuan.

China reported fiscal revenue at 22 per cent of GDP and industrial profit at 12 per cent of GDP in 2011. The household disposable income survey suggests household income was 40 per cent of GDP. Suffice it to say that China's income distribution is heavily skewed towards the government and state-owned enterprises; household disposable income is low, and this is why China's consumption is low.

On the supply side, China suffers extreme fragmentation and overcapacity. When labour and capital were cheap and supply was endless, such an industrial structure could survive. But, as China's demographic headwind pushes up wages and inflation pushes up capital costs, most businesses in China are having trouble. To survive, numerous companies have turned their core businesses into a fund-raising platform for property speculation. This strategy is backfiring as the property market heads south.

China's bubble has covered up many structural problems. The bubble worked when the benefits from other sources were available to sustain it. As the latter vanish, the bubble deflates. Obviously, it is painful to deal with all the problems at the same time.

The obsession with stability may be pushing China towards a stalling strategy. China's vast foreign-exchange reserves give it the freedom to maintain domestic liquidity regardless of the quality of the banking assets or hot-money outflows. The lack of liquidity pressure means China doesn't have to press bankrupt developers and inefficient businesses to sell out or liquidate. But that could lead to a Japan-style equilibrium with zombie banks, zombie companies, and zombie local governments.

Unlike Japan two decades ago, China's labour costs are still low. It is possible that, through multinational corporations and new companies at home, Chinese workers will become more productive, for example, by competing against their German and Japanese counterparts. The resulting rising tide could solve China's problems. But this strategy needs luck, and time, to work.

It would be far better to control one's own destiny through restructuring to become more productive on the supply side and more balanced on the demand side. But the prospect of that seems low for now. China's economy may take a long pause.

Andy Xie is an independent economist

Monday, January 16, 2012

Slow growth era may have arrived

January 16, 2012 / Andy Xie



China's economy is slowing down due to export weakness and a bursting property bubble. Unless painful structural reforms are undertaken, the slow growth may be here to stay.

China has excessive debt in the corporate sector due to property speculation, excessive fragmentation of the supply side due to local government subsidies, and unsustainable dependency on investment on the demand side. Export slowdown and property bubble bursting expose their drag on growth. Unless structural reforms deal with these problems, China is entering an era of slow growth-GDP growth rate down by one third or more compared to the record in the last decade.

The structural problems are unlikely to be cured in the foreseeable future. China is likely to avoid widespread business bankruptcies, which is necessary for balance sheet cleansing and supply side consolidation, by forcing banks to prop up unprofitable businesses. This dynamic will suppress economic growth rate.

Fiscal or monetary stimulus couldn't revive growth. The stimulus money would go into government fixed investment, already excessive, inefficient, and inflationary.

China's per capita income reached $5,000 in 2011. It is less than half of the global average and one tenth of the OECD level. China has the potential to continue high growth rate until $15,000 per capita income. However, the will to embrace painful reforms, necessary to realize China's full potential, isn't here.

Too much debt


China's debt is concentrated in the business sector and local governments. It appears that both are excessively in debt and will have trouble expanding through more debt. At a glance China's economy isn't excessively levered. The domestic credit at Rmb 65 trillion reported in October 2011 is about 145% of GDP. It is not alarmingly high by itself. But, the off-balance assets in the banking system and the lending activities outside of the formal financial system may add considerably to the country's indebtedness. The financial institutions have total assets of two times GDP. And the country's officially recognized financial assets are about 2.6 times GDP. These two numbers indicate that the lendings outside of the officially recognized financial system are considerable. China's total indebtedness of its non-financial sector is probably above 200% of GDP.

The concentration of China's debt in local governments and businesses is a big problem. Local governments usually have debts over three times revenue. There are examples of over ten times. Corporate debts in many coastal townships are above two times the local GDP. Such high leverage is difficult to sustain. It is quite likely that both sectors are having trouble paying off their debts.

Corporate debts usually go into property investments that in turn become revenues for local governments. As the property bubble bursts, the revenues for local governments will come under pressure. That increases the difficulties for local governments to pay off their debts.

The inability to pay off debts is not likely to lead to bankruptcy. The recent trend suggests that the banks will roll over the loans to governments or businesses despite their inability to repay.

Fragmentation of the supply side


Most businesses in China seem to have a large number of companies, while similar industries in the rest of the world are consolidated into a few players. Low entry costs are the reason for China's fragmented industrial structure.

Local governments keep entry costs low to promote investment. Land is commonly free for industrial use. The environment protection cost is usually low. Until recently, credit and labor were cheap and plentiful. In an environment of low entry costs, market growth leads to more entries. Hundreds or even thousands of companies are doing the same thing across most industries.

The fragmented industrial structure is running into trouble due to rising labor and credit costs. A fragmented industry has no pricing power. When costs rise, only bankruptcies could shrink output, increase prices, and restore profitability. The logical ending in this process is the emergence of large players that develop brand, quality, intellectual properties, and economies of scale as entry barriers.

However, the consolidation process led by market force is unlikely to proceed normally. The lenders are under pressure not to pull the credit lines on struggling businesses. That means that the industrial sector couldn't improve efficiency to deal with rising costs.

Unbalanced demand


Excessive investment, led by local governments and state-owned enterprises, has become the central pillar for demand management in China. As debts pile up, more investment with new debt has become the only option to keep liquidity positive. This dynamic of riding the tiger is leading the Chinese economy to become more and more skewered towards investment.

In 2001 the reported urban fixed asset investment ('FAI') was 25% of GDP. It surged to 43% in 2006, 60% in 2010, and an estimated 65% in 2011. The increase in the FAI over the past decade exceeded three quarters of GDP increase. The trend is simply crazy.

China's FAI is supply-driven, i.e., it starts with a government project. The government concerned then tries to raise revenues in whatever way at its disposal. As government power is unchecked, such dynamic inevitably leads to squeezing the household sector through whatever channels. High property price, inflation, taxes, or fees all lead to the same end: funding government projects.

The reported FAI could be exaggerated due to leakages in the expenditures. China's gray income could be one tenth of GDP. Much of it comes out of FAI. Such redistribution of income from the masses to a privileged few is not good for social stability. That is one reason that the FAI trend is bad for the country.

Leakages aside, some of the massive investment is just waste. The image projects are visible everywhere. China's per capita income is less than half of the global average. It doesn't make sense to waste money on such a scale.

Stimulus could backfire


China's economy is slowing significantly since the summer of 2011. The eurozone debt crisis was the trigger. It appears that Europe is experiencing a deeper recession. It is the largest trading partner for China. The bursting property bubble at home is adding to the slowdown. The property bubble has been the liquidity machine turning bank loans to property developers and buyers into revenues for local governments that leverage up the receipts further with bank loans to fund FAI. The breakdown in this liquidity machine has forced many governments to stop FAI projects.

As the slowdown continues, there will be calls for monetary and fiscal stimulus. Such stimulus will merely go into FAI again, prolonging the problems in the economy. Inflation will follow such stimulus. It is just taxing the currency holders to finance inefficient FAI. While stimulus for propping up FAI isn't a good idea, it may happen anyway in 2012. The resulting inflation will cause public outcry and pullback of such stimulus.

China's current slowdown isn't just a cyclical phenomenon. The country's investment-and export growth model is running into a wall. Global trade isn't likely to return to high growth. Without export boom, there is no income to afford the inefficient FAI. Pure cyclical thinking in policy prescription isn't likely to get the economy out of the doldrums.

Structural reforms can revive high growth


If China wants to revive growth, it should allow market force to function fully. Unviable businesses should shut down or be sold. China's cost structure will continue to rise due to labor and energy shortage and rising cost for environmental protection. Fragmented industrial structure is just not viable. Consolidation into the right hands could increase efficiency to offset the cost rise.

Further, China has to move up the value chain to deal with the rising costs. While China's exports are the biggest in the world, Germany and the US are not so far behind. Their labor cost is ten times China's. They are sustaining their exports by doing what China cannot. It is a big market out if China can upgrade and move into the same markets that Germany, Japan, and the US occupy now. The current industrial structure couldn't get China into the high value added market, as companies are too small and profits are too low to fund R&D. Consolidating the current fragmented industrial structure is a must if the country is to move its industrial base up the value chain.

The concentration of resources in the government sector has become a drag on the economy. This political force is the root cause for most of China's problems. The trend needs to be reversed if the economy is to move up the value chain. China should consider to decrease the government's stakes in the state-owned enterprises and to open up the industries that the SoEs now monopolize to private companies.

Demand support is worthwhile if it coincides with structural reforms. Otherwise, it would be just for propping up an inefficient and unsustainable economic structure. And, any stimulus should support consumption rather than investment to ease structural imbalance.

As I wrote in this page last time, cutting taxes is the best way to support demand. Monetary stimulus or increasing fiscal spending would only support inefficient FAI, making the situation worse down the road.

Stagnation for stability?


The micro evidences suggest that China is trying to prop up the existing structure rather than to restructure the economy. Local governments are putting pressure on banks to support failing companies. The local government debts are likely to be rolled over too. While such actions preempt disruptive bankruptcies, businesses, banks, and local governments could all become zombies for a long time to come. Stability will be paid with stagnation.

China's attitude to the current economic challenges seems to be similar to Japan's two decades ago, emphasizing stability above all else. Japan essentially buried the consequences ot the bubble in the financial system. Businesses, banks, and local governments all became zombies. Of course, China is entering the phase at much lower per capita income. Stagflation will trap hundreds of millions of people in low income.

It is possible that China will emerge from the low growth phase on its own as businesses eventually learn to use China's labor for higher value-added activities. Import substitution and export expansion may follow, which would bring a rising tide again. But, it would be years away. Unless we see a coherent and comprehensive restructuring program soon, China may be stuck in low growth for years.

It doesn't have to be that way


China's per capita income is only USD 5,000. The household consumption is merely one third of that due to over investment. China's living standard is still relatively low. It would be a trajedy for China to be stuck at such a low level.

Two decades ago, Japan was already enjoying per capita income similar to other developed economies'. Stagnation wasn't a bad prospect. Also, due to high cost, Japan wasn't in a position to revive high growth rate. One may argue that Japan made a rational choice to digest the consequences of the bubble over a long time.

The tradeoffs for China today are totally different from Japan's then. The country still has low cost. Through upgrading, high growth rate could be revived. The current per capita income is too low for most people.

Avoiding bankruptcies is very bad for the stock market. Failing businesses that are propped up by the banks will suppress profits for healthy companies. The banks will suffer terribly. Hence, the stock market will remain depressed due to low profitability. The government may try liquidity support for the stock market sometime this year. Its effect will be short-lived. Without a good environment for business profit, the stock market cannot perform.

As I wrote before, soft landing may not be good, hard landing may not be bad. Indeed, if China goes into a hard landing now, it will most likely push the country towards painful reforms. The economy will prosper for a long time afterwards. But, it doesn't look likely now. China's economy is slowing down in an orderly fashion, as the banks are not permitted to pull the plug on failing companies. When we celebrate the soft landing, we should remember the cost.

Tuesday, December 20, 2011

The last article of year 2011

Dear All,

This is my last article for 2011. Hope you have enjoyed my articles during the year. 2011 is a very difficult one for everyone. The first half of 2012 may be worse. There is just so many baggage from the past yet to be cleared out. The past cannot be covered up anymore.

I'm in Zhejiang now, talking to bankers about unique credit risks here associated with businessmen gambling in Macau. Bankers literally try to take away their borrowers' pass for entering Macau. But, somehow, they manage to get into without the pass. This is such a big deal that threatens the health of China's economy. Macau threatens China's stability.

High interest loans are a bigger destabilizing force yet. Its fall impact is yet to be felt. So many still count on land price coming back to save them. The land bubble here is gigantic, all based on the assumption of land shortage. There is no land shortage in China. The land price surge is just a debt bubble. The land price can easily go down over 70%.

Another assumption is that the government won't let the land market go down like that. But, the monetary expansion required to support the bubble will lead to hyperinflation and currency devaluation. Chinese government isn't bigger than the market.

It all feels like the big storm is about to come down on us soon. What we have seen is merely drizzle.

Wish everyone Merry Christmas and Happy New Year!


2012: the BRIC bubble bursts

Andy Xie, December 20, 2011



The world has become more volatile in the months ahead of 2012. The odds are that the world will experience explosive volatility in the first half of 2012. Two forces will drive volatility. First, the global financial crisis of 2008 has become political crisis in the west. The political instability will escalate amidst general elections in Europe and the US. Second the debt bubble in the emerging economies is bursting as hot money flows back into the US.

The emerging market growth, partly due to the credit bubble, kept the global economy afloat in the past three years. As the bubble bursts, the global economy is likely to go into recession again. That will force the Fed and ECB to expand QE to stabilize their economies. The global financial markets may cheer up in the second half of 2012. But, that would be just a bounce, not the beginning of a new trend.

The health of the global economy depends on major countries to undertake serious political reforms. If the necessary reforms are not undertaken, more QE just leads to higher inflation down the road. Even if the reforms take place, it will take years to change the economic trend. Stagflation remains the dominant trend for the global economy.

The economic improvement since 2008 is largely a mirage, fueled by unsustainable government assistance in the west and bubbles in the emerging economies. Both will unwind in 2012. The mirage will be unmasked. If you think 2008 was bad, fasten your seatbelt for 2012. The world may not end. Your wallet might.

From financial crisis to political crisis


The global financial crisis ('GFC') of 2008 was quickly followed by an economic crisis. To stop the economic collapse, major economies bailed out failing financial institutions and companies and launched massive monetary and fiscal stimulus. The hope was that the stimulus would jumpstart another growth cycle that would cover the cost of bailouts and stimulus.

It is apparent by now that the stimulus generated only temporary and anemic growth. The high cost of stimulus has led to fiscal crisis in most western economies. In the eurozone it has become sovereign debt crisis as the bond market doubts the solvency of several major economies. The difficult politics of cutting fiscal deficit is leading several countries into political crisis.

In the US, the Congress and the Whitehouse battle constantly over the budget. The government is constantly threatened by shutdown. The recent compromises only provide finance for the government on a very temporary basis. As the presidential elections draws closer, the political fighting would become fiercer, increasing the probability of a government shutdown that would create a big economic shock.

In the fiscal year that ended at the end of September 2011the US's fiscal deficit was $1.3 trillion that was equal to 8.6% of GDP, 36% of the total expenditure, and 57% of the fiscal revenue. The US has never been under so much pressure before. In the past, it mostly counted on growth to solve its deficit problem, mainly by capping expenditure and waiting for revenue to catch up. The US's growth potential seems significantly lower than before. The level of the fiscal deficit is unprecedented. The US cannot count on growth to solve its fiscal problem and must embrace serious austerity.

The politics of cutting the deficit is explosive. The Democrats and Republicans virtually have no commonality in how to solve the deficit. The Republicans refuse to consider raising taxes. The Democrats don't want to touch welfare programs like medicare and social security. Their positions mean that there is no political solution likely. As the presidential election draws nearer, the politics could become explosive. In particular, street protests may shock the political system. Of course, some outside force like street protests is probably necessary for the two party system to function again. The process will be highly volatile. Financial markets may suffer.

The US presidential election in 2012 may turn out to be as tumultuous as the one in 1968. The Democrats will likely campaign for fairness, while the Republicans for shrinking the government. The political positions of major interest groups are irreconcilable. Violence may mar the US. While the US economy seems holding up for now, a confidence crisis over the political fighting could set the economy back again.

The eurozone debt politics is more complicated and urgent. The US's Fed keeps the treasury yield low, giving the US government time to solve its deficit problem. The ECB isn't playing that role. Hence, the indebted countries like Italy and Spain are at mercy of the bond market. When the market is jittery, they just won't have the money to run their governments. Hence, bond market turmoils quickly become political crisis. While the new governments of Italy and Spain are serious about austerity, the bond market is unlikely to be convinced. Negative expectation is self-fulfilling in the current environment. Unless the ECB changes its position, the market is unlikely to change its mind, regardless of how aggressive Italy and Spain are in their austerity.

European elite seem to be consolidating behind Germany to save the euro through austerity. Selling the solution to their peoples may turn out not as easy. The drop in living standard could be over one fifth in Southern European countries. It is hard to imagine that such a big cut in living standard could be accomplished without social violence. The austerity is likely to generate political crisis in Italy and Spain. The magnitude of reduction in living standard in these countries and the high unemployment resulting from the poor economy could lead to violent street protests, which would make the bond market more negative. The eurozone is likely to be locked in this vicious cycle in the first half of 2012.


The BRIC bubble bursts


When the western debt bubble burst in 2008, their governments released huge amounts of money through central bank printing money and deficit spending. Because their financial systems were in trouble, the money flowed to emerging economies, triggering massive debt growth in emerging economies. In particular, the hot money flowed into the BRIC countries. China's broad money has risen by 80%, and India's 60% in the past three years. Outside of the monetary system, credit instruments have proliferated in the emerging economies.

The BRIC economies may experience serious economic difficulties next year. Some may experience old fashioned currency crisis. Three forces are bursting the hot money bubble in the BRIC countries. First, the dollar is on the rise. The Washington gridlock is limiting the US fiscal expansion. The dollar is rising as a result. Second, the overextended European banks are shrinking by trillions of euros. This force is swallowing up massive amount of liquidity. The ECB is yet to increase liquidity sufficiently to offset it. Third, China's property bubble is bursting. It is bringing down commodity prices that have been supporting growth in emerging economies.

Brazil and India could experience significant currency depreciation. If not handled properly, for example, propping up their currencies with their limited forex reserves, they could experience full-blown currency crisis, as soon as their forex reserves are exhausted. Despite favorable terms of trade, Brazil and India have run substantial current account deficits, because their monetary condition was excessively stimulative of domestic consumption. Still they have amassed significant forex reserves thanks to hot money inflows more than enough to financing their current account deficits.

India runs a trade deficit of about $10 bn per month or 7-8% of GDP. The deficit is financed by service exports to the west, overseas income of Indian labor, and hot money inflow. All three financing sources are drying up. The west isn't in a position to buy Indian services like before. India's labor income is threatened by the turmoils in the Middle East. And, of course, hot money is reversing. India's foreign exchange reserves of about $300 bn could be exhausted quickly to fund hot money outflow. The stock of hot money in India is probably twice as much as its forex reserves. When the run on the rupee begins, India's reserves could be exhausted in days. India's best defense is to let the currency go, rather than defending it, as Indonesia did during the Asian Financial Crisis. India's forex reserves relative to GDP are about the same as Indonesia's before the Asian Financial Crisis.

Russia has been kept afloat by its energy exports. The Putin prosperity is due to the global energy boom. Russia's industries have declined. If the energy boom ends, Putin's Russia won't have the money to buy the loyalty of the population in its vast hinterland. Among all the commodities energy has the best fundamentals. Russia could be lucky again. However, the global recession could bring down energy prices, even temporarily. Russia doesn't have a big cushion in its model for social peace.

China's forex reserves are ten times India's. Its capital account is not open. Hence, hot money outflow is unlikely to overwhelm China's currency. But, China's vast property bubble is bursting. The bubble has exaggerated China's growth and grossly distorted the money allocation. The normalization will be protracted, possibly lasting through 2014. The rebalancing may cut the real economic growth rate by half. Also, the bubble supported the vast gray income, possibly 10% of GDP. As the bubble bursts, the burden is impossible for the real economy to support. If history gives any guidance, China is about to launch a vast anti-corruption campaign as a necessary component of the normalization to ease the burden on the economy.

More QE


The Fed shifted its asset purchases to long dated treasuries in September to increase the power of its quantitative easing. It wasn't a full blown QE 3, more like QE 2.5. The US economy has been stabilizing in the recent months, generating jobs roughly in line with labor force growth, i.e., the unemployment situation isn't deteriorating. But, this is fragile stability. The US's housing crisis isn't over. One fourth of homeowners with mortgages, roughly one tenth of the nation's properties, have negative equity, which threatens the economy with more foreclosures. Cutting fiscal deficit could weaken demand. More immediately, the global environment threatens.

The US is quite dependent on exports to Europe. The eurozone is in a credit crunch, like East Asia in 1998 and the US in 2008. It would lead to a big recession, possibly 3-5% contraction in the eurozone GDP. The US export may fall sharply due to that.

Emerging economies have supported the global economy in the past three years. The exports of developed economies like the US have benefited. The profits of the global companies have become dependent on the emerging market boom. That has supported employment and financial markets in the developed economies. As the emerging economies weaken sharply in 2012, that important support is gone. The double negative shock from eurozone and emerging economies could send the US economy into tailspin again. The impact may become apparent by the second quarter of 2012. That may convince the Fed to pursue QE 3.

The only way out for the eurozone is for the ECB to be like the Fed, i.e., holding down bond yields for countries like Italy and Spain. It isn't doing so because Germany opposes. Unless Germany changes its mind, the crisis will keep deteriorating. That may occur when German people see the crisis coming to them. So far they think it's someone else's problem. Germany completely depends on exports. The eurozone recession and the sharp slowdown in the emerging economies will likely send Germany into recession too. The German stock market seems to predict it. When German companies have to lay to workers, Germany people may change their mind.

The ECB, with Germany's blessing, may provide credible support to troubled sovereign debt markets. I suspect that it would need to put €1 trillion on the line to achieve the desired effect.


Stagflation ahead


The ECB and Fed may pursue more QE in the second half of 2012. That will be too late to stop the burstin of the hot money bubble in the emerging economies and the severe recession in Europe. If they do so now, the European banks don't have to contract so fast, and the hot money may stay in emerging economies. But, central bankers don't look forward this way. They check the current statistics and make their decisions.

More QE may bring temporary relief to financial markets. But they won't restore economic growth on their own. The global economy suffers from structural problems cumulated over the past two decades. Reforming is a long and arduous process. Reviving growth is just not possible. QE only leads to stagflation.

Wednesday, December 14, 2011

Shattered illusions

Andy Xie forecasts escalating volatility in the global economy next year as the West begins to pay for its past excesses and the emerging economies, led by the BRICS, try to pick up the pieces after the credit bubble bursts

Andy Xie
December 14, 2011

Next year may be the most volatile year in two decades. A political crisis may engulf major countries in transition. The financial crisis that began in the United States and is now raging in Europe could take down some major emerging economies that have been relatively stable.

The BRIC economies may experience serious difficulties next year. Some may suffer an old-fashioned currency crisis. The major central banks in the developed economies loosened monetary and fiscal policies to cope with the financial crisis in 2008. A significant chunk of the money has flowed to emerging economies, especially the BRIC countries. The hot money has sustained their growth so far. Unfortunately, the growth is mostly an old-fashioned credit bubble.

Three forces are bursting the hot-money bubble in the BRIC countries. First, the dollar is on the rise. The Washington gridlock is limiting US fiscal expansion, and the dollar is rising as a result. Second, the overextended European banks are shrinking by trillions of euros and swallowing up massive amounts of liquidity. The European Central Bank has yet to increase liquidity sufficiently to offset it. Third, China's property bubble is bursting, bringing down commodity prices that have been supporting growth in emerging economies.

If the ECB and the US Federal Reserve launch substantial quantitative easing soon, the hot-money bubble in the BRIC countries could be restored. But, I suspect that it would come too late and the amount would be insufficient. Next year may turn out to be when the BRIC bubble finally bursts. BRIC is one word that launched a thousand hedge funds and a gigantic hot-money bubble. Only the dotcom craze a decade ago had the same impact.

Brazil and India could experience significant currency depreciation. If handled badly - for example, by propping up their currencies with their limited foreign exchange reserves - they could experience a full-blown currency crisis as soon as their foreign exchange reserves are exhausted. Despite favourable terms of trade, Brazil and India have run substantial current-account deficits. Nevertheless, they have amassed significant foreign exchange reserves, thanks to hot-money inflows.

India runs a trade deficit of about US$10billion per month, or 7-8per cent of gross domestic product. The deficit is financed by service exports to the West, overseas income of Indian labour and hot-money inflows. All three financing sources are drying up: the West isn't in a position to buy Indian services like before; India's labour income is threatened by the turmoil in the Middle East; and, of course, the flow of hot money is reversing. India's foreign exchange reserves of about US$300billion could be exhausted quickly to fund hot-money outflow; the stock of hot money in India is probably twice as much as its foreign exchange reserves. When the run on the rupee begins, India's reserves could be exhausted in days.

India's best defence is to let the currency go, rather than defending it, as Indonesia did during the Asian financial crisis. India's foreign exchange reserves relative to GDP are about the same as Indonesia's before the 1997 crisis.

Despite its declining industries, Russia has been kept afloat by its energy exports. The Putin-era prosperity is due to the global energy boom. If the boom ends, Vladimir Putin's Russia won't have the money to buy the loyalty of the population in its vast hinterland. Among all the commodities, energy has the best fundamentals. Russia could be lucky again. However, the global recession could bring down energy prices, even temporarily. Russia doesn't have a big cushion in its model for social peace.

China's foreign exchange reserves are 10 times those of India. Its capital account is not open. Hence, hot-money outflows are unlikely to overwhelm the renminbi. But the mainland's property bubble is bursting. The bubble has exaggerated growth and grossly distorted money allocation. Normalisation will be protracted, possibly lasting through 2014, and the rebalancing may cut the real economic growth rate by half. Also, the bubble supported the vast grey income, possibly 10 per cent of GDP. When the bubble bursts, it will be impossible for the real economy to support the burden. If history is any guide, China is about to launch a vast anti-corruption campaign as a necessary component of the normalisation to ease the burden on the economy.

The West will be marked by political crisis next year. Its loss of competitiveness to emerging economies and an ageing population will cause living standards to drop. This need was postponed by the debt bubble for a decade. Even Europe and the US stabilise their financial systems for now, leaders will still need to deal with the reality of cutting living standards - and this is tricky politically.

In the US, the presidential election next year may turn out to be as tumultuous as the one in 1968. The Democrats will probably campaign for fairness; the Republicans for smaller government. The political positions of major interest groups are irreconcilable. While the US economy seems to be holding up for now, a crisis of confidence over the political fighting could set the economy back again.

The European elites seem to be consolidating behind Germany to save the euro through austerity. But selling the solution to their people may not be so easy. It is hard to imagine that such a big cut in living standards could be accomplished without upheaval.

The economic improvement since 2008 is largely a mirage, fuelled by unsustainable government assistance in the West and bubbles in the emerging economies. Both will unwind next year. The mirage will be unmasked. If you think 2008 was bad, fasten your seat belt for 2012. The world may not end, but your wallet will take a hit.

Andy Xie is an independent economist

Monday, October 17, 2011

Usury and monetary policy

2011-10-17  / Andy Xie



The bankruptcies of many private enterprises, especially in Wenzhou, are mostly due to speculation with borrowed money gone bad. It is totally wrong to characterize this phenomenon as monetary tightening squeezing SMEs. Normal businesses don't go bankrupt because they cannot borrow. Only money burning speculation needs to borrow constantly to stay afloat.

Loosening monetary policy now to ease the liquidity crunch for speculators would do enormous harms to the economy. Indeed, the excessive monetary expansion between 2008-10 squeezed real businesses through cost push and rewarded speculation through asset inflation. Another wave of excessive monetary expansion will magnify manifolds the speculation in China's economy by proving again that speculation, not honest business, is profitable. The ultimate crash will be much bigger.

High interest rate lending is turning into a ponzi game or 金融转销 in many tier II and III cities. The phenomenon seems quite widespread. Zhuanxiao is a constant threat to China's social stability. Financial zhuanxiao has disruptive power many times of the usual type. If not stamped out soon, it could cause widespread social instability next year.

China is facing manual labor and energy shortage. The ongoing economic slowdown is a good thing. Pushing growth would only worsen inflation. To achieve another wave of high growth, China must rebalance its economy away from manual labor and/or energy- intensive industries towards higher value added activities.

A good thing gone bad


The underground lending has a long and productive history in China. It reflects that China's state-owned financial system couldn't meet all the market demand. Underground financing is a major force behind the export-led economic boom along the coast. The SMEs in PRD and YRD have benefited from the availability of financing through such channels. And they have been the main force in China's export boom.

Financing through informal channels is the main source of financing for SMEs throughout the world. Formal financial institutions just don't have the cost structure to service SMEs effectively. Hence, the government shouldn't stamp out informal financial channels because they sometimes create problems like now. Overall, informal financing contributes to the economy.

The nature of the underground financing in China has shifted in the last five years, away from real economic activities to property and financial speculation. The reason is obvious. Speculation has been profitable due to massive monetary expansion, while real businesses have been squeezed by weak global demand and rising costs.

Should we blame underground financing per se for creating the bubble? Not really. No financial institutions could go against the macro environment. Even the best managed banks rarely survive a loose monetary environment intact. Financial institutions are just not equipped to handle macro risks. The 2008 financial crisis and the current euro debt crisis demonstrate this point.

There is little doubt that China's banks have played a dominant role in turning monetary expansion into a massive property bubble. Underground lending has played a supporting role, often funding fake equity for qualifying for bank lending.

Macro tightening bridge loan?


The lending rates in the underground financing market range between 20-100%. Hardly any business in the real economy has returns so high to afford such high interest rate. The borrowers of such high interest loans can only hope to repay the loans through asset appreciation.

For example, land owners have turned to high interest borrowing to hang onto their land holdings while the monetary tightening has limited the availability of bank loans. Many property developers view the tightening as temporary, like in 2008. Hence, they view high interest borrowing as a bridge loan for getting through the tightening window. When the tightening ends soon, as they expect, the land price would surge far more than the interest they would have to pay.

Extrapolating from the most recent past is always dangerous. The 2008 global crisis changed the Chinese government's mind from fighting inflation to supporting growth. The decision doesn't look so smart today. China's labor shortage was already obvious then. The stimulus has worsened inflation problem enormously, while the monetary growth, due to shortage of opportunities in the real economy, has primarily gone into property market. China is facing tremendous difficulties today because of the unwise stimulus policy then.

It would be extremely unwise to expect the government to loosen up and stimulate growth now. If so, it would be a bigger mistake than the previous stimulus, because the economy will experience even more excesses. Another stimulus package like the one in 2008 could trigger hyper inflation and hyper speculation in China. The consequence wouldn't be just another burst. It could lead wholesale political changes. It is difficult to imagine that the central government would take so much risk with little upside and so much downside.

Property developers that depend on high interest loans are making a huge mistake. They should resort to price cutting to increase sales rather than selling little at high price while depending on high interest loans for liquidity. The later they wake up, the deeper price cuts they have to do eventually. Of course, when the market clearing prices are 50% less than the recent peak, many developers would go under.

It is necessary for many, if not most developers, to go under. Unless it happens, the tightening wouldn't have worked. Otherwise, it would be business as usual, i.e., the economy depends on bubble making for growth.

High interest lending may have turned into a ponzi game


While the demand from property market started the high interest lending boom, it seems to have turned into a Ponzi game or financial zhuanxiao lately. Because real interest rate is too low, stock and property markets are depressed, and the real economic activities have low profitability, savers have become credulous about opportunities like high interest lending. They worry their bank deposits are depreciating in real terms. Also, 20-100% interest rate has the smell of 'get rich quick'. There are always numerous people who are suckers for that. So many want to believe its sustainability and dream how rich they would be in a few years.

There are no activities in the real economy that could bear such high interest rate. Financial speculation doesn't look so either. The property market is declining. The stock market is depressed. So where could the high interest lending go?

In the past two months, I have travelled along the coast and up the Yangzi River. High interest lending seems booming. Even in interior cities commercials are everywhere advertizing the business. There are so many people involved, it seems. As the end demand seems dubious, I have to conclude that this business is now a Ponzi game, relying on new money to pay off the old money. I haven't seen anything before. It is quite scary.

A Ponzi game is a redistribution game. Unfortunately, the last ones to hold the bag are often the most vulnerable and credulous, like low income group and retirees, in the society. When they lose everything, they will turn on the government. There are plenty of examples from the past. The central government should deal with it now to control the risk. As this involves criminality, the central government should mobilize security apparatuses to deal with this.

China experiences pyramid schemes or chuanxiao (传销) frequently. The security apparatuses deal with it on a daily basis. This is the first time that chunaxiao has become a financial phenomenon. If not checked, it could lead to a national calamity.

Monetary growth is not too tight


The current level of monetary growth is more than adequate for China's economy under normal circumstances. M2 grew by 13.5% in August from last year. It is much lower than 20% in recent years, but still considerably higher than China's potential growth rate. China's financial depth is already very high with total assets of deposit taking corporations above 2.3 times 2011 GDP. Hence, monetary growth above the potential growth rate of the economy will become inflation.

Also, the current M2 growth rate may be underestimating the true magnitude of monetary growth. Commercial banks have been active in off balance sheet activities in response to tighter lending restrictions. The trust sector has been booming. The underground high interest rate lending market has been surging. These activities are not fully reflected in the monetary statistics. If these activities are taken into account, I suspect that the apple-to-apple comparison would give us 16% broad money growth rate.

Inflation is still the challenge


Inflation remains China's main challenge. The massive growth in money supply over the past decade is still turning into inflation. The level of monetary growth is not low enough to subtract from it. China isn't really pushing inflation back into the bottle yet.

The structural changes have made China's economy much more inflation prone. Three decades of one-child policy is cutting today's labor supply. China's manual labor supply may not be growing at all. Factory and construction drive China's growth. Unless the growth rate slows down significantly, labor shortage will wosen, increasing inflation as a result.

Energy shortage is another factor driving inflation. The official statistics may show China's coal consumption at 3.6 billion tons and, including production above government approved quotas, possibly at 4 in 2011. Double digit growth rate of coal consumption on such a large base is unsustainable. The transportation system won't be able to handle that. Also, the production levels in viable production locations may be peaking. China's growth model is highly energy-intensive. If the growth rate of coal consumption remains at double digit rate on such a large base, energy prices will continue to inflate.

While monthly inflation data may fluctuate and sometimes show cooling inflation, the underlying forces are still for inflation. It would be wrong to shift macro policy priority away from price stability.

Slowdown has little downside


Unlike a decade ago, economic slowdown today has little downside. The shortage of manual labor is still worsening. A slowdown will hardly cause an employment problem. The SMEs that are going bankrupt may lead to layoffs. But, the affected workers can find jobs quickly elsewhere.

There is an employment problem for six million college graduates per annum. The wage gap between those with and without college degree is virtually not existent, at least at entry level. A large number of college graduates, unable to find satisfying white-collar jobs, are staying home. Considering how much they have cost their parents in going through four years of college, the current situation is not acceptable. It is a destabilizing force.

However, the answer to this problem isn't pushing growth. Construction and factory drive growth under the current model. It needs blue collar workers. The answer to the insufficient employment of college graduates lies in reorienting the growth model towards higher value added activities.

The way forward is rebalancing


China's next growth cycle must be less labor and energy-intensive. Otherwise, inflation will surge to derail any growth push. China must reform its economy and give more power to market and private sector. The dominance of the state-owned enterprises inevitably leads to big project-led growth, which is too inflationary.

The starting point of rebalancing China's economy is to limit the revenues of the government sector. The fiscal revenue and SoE profit may reach 30% of GDP in 2011. The SoEs also spend considerable more than their profits on capital expenditure. Local governments also increase their net borrowings to increase spending. If these factors are taken into account, the government state may spend half of the money in the economy.

China's private enterprises and household sector have been marginalized in the past decade. China's consumption is a small share of GDP because the household sector doesn't have the cash flow to support higher level of consumption. Unless the government sector takes less money out of the economy and leaves more for the household sector, big project construction will continue to dominate the economy.

Also, the current economic structure gives profitable opportunities mostly to SoEs. Private companies are left with low margin businesses like light manufacturing and retailing. Only the property sector has delivered good returns mostly through land inflation. This is why so many private companies have moved into property development. As the property bubble deflates, the private sector will become much smaller.

The rebalancing of China's economy begins and ends with limiting the size of the state sector. Anything else is just diverting attention. To limit the government size, the first step should be to cut taxes. For example, the top personal income tax rate should be cut to 25% from 45%, and the VAT should be cut to 12% from 17%.

Through rebalancing, China's economy will shift to higher value added growth. Only then could China revive high growth rate without sparking inflation.

Deflating property bubble is the answer to tight liquidity


The current liquidity problem, as reflected in bank lending restrictions and high interest rate in the underground financing market, is due to excessive demand, not supply too low. As argued above, the current monetary growth is more than sufficient under normal circumstances. The excessive demand comes primarily from the property sector. The properties under development may exceed 50% of GDP in value at last year's price.

The way out of the current liquidity problem is for property market to deflate. When the price comes down, the property market needs less liquidity.

Increasing money supply isn't the answer to the current liquidity problem. It will encourage speculation and exacerbate inflation, ultimately leading to an economic collapse.

Friday, October 14, 2011

Start the international board now

A country becomes a financial center because it has succeeded in becoming the trade center.

Germany's plight today should remind everyone that, when the financial center and the source of money are disconnected, bad things happen to whoever has the money.

Even though Germany amassed the biggest trade surplus in the past decade, its financial system was woefully underdeveloped and relied on London bankers to recycle its money into other countries. With the benefit of hindsight, it would be natural that the London bankers wanted to screw Germany, because they were paid to do so.

In a decade or two, Germany may become a poor country. When people look back then, they would conclude that its decline was due to the combination of a hyper competitive manufacturing sector and a woefully inadequate financial sector.

China's total property value, including work-in-progress and land banks, is already 5 times GDP. The bubble is about 100% above the sustainable level. When the bubble is big enough, China will run trade deficit rather than surplus. But, it is artificial. When the bubble bursts, the currency gets devalued, the property value drops to 2.5 times GDP or less. It would lead to a huge trade surplus of above 10% of GDP. But, the world won't tolerate that. The resulting protectionism would shut down the global economy for everyone.

The only good way out is for China to develop a global financial center that would allocate China's trade surplus effectively and efficiently to boost global economic growth. If China can allocate its surplus capital into the global economy efficiently, it can continue to earn surpluses.

To develop a financial center, a country must have the rule of law, the strong protection for private property, and transparency. China lacks all three. It will take a long time to develop them. But, a downpayment in the form of an international board at China's Stock Exchange could help to jump-start the process.

2011-09-12  / Andy Xie



China must effectively internationalize its surplus capital for the global economy and its own to function normally. Otherwise, the global economy would suffer bubbles and financial crisis again and again. It may lead to the rise of protectionism that would destroy the global economy.

Irresponsible borrowing by Southern European governments and Anglo-Saxon households and money hoarding by Germany, oil exporters, and East Asian manufacturing exporters planted the seeds for the current crisis. China's share among surplus countries is rising. If China keeps recycling its surplus into government bonds, the resulting distortion would hurt itself and others. The country could become the focal point in the international blame game.

Globalizing China's surplus labor has led to its economy rising over twentyfold in nominal dollar value and becoming the largest trading economy in just two decades. Globalizing the country's surplus capital would make China the largest economy in the world and the biggest financial center in another two. This action is in China and the world's best interest.

The first step in internationalizing China's surplus savings should be to start the international board of the country's stock market. It is a small downpayment but may produce a large effect on the global economy through inspiring multinational companies to expand production. As the global economy double-dips, this action would be China's contribution to supporting the global economy.

As the second largest economy, the largest trading nation with the largest trade surplus, China must take significant responsibility for the healthy functioning of the global economy. Its foreign assets of $4 trillion are overwhelming in government bonds. This lopsided allocation has created huge distortion in the relative price between bonds and stocks. This distortion is a destabilizing factor for the global economy. It should be remedied as soon as possible.

From labor surplus to capital surplus


Globalizing China's surplus labor is the single most important factor in China's economic development over the past two decades. The surplus depressed China's labor cost to less than 5% of that in the developed economies two decades ago. But, China's labor quality was several times higher than the relative wage suggested. Opening up the country to FDI and building supporting infrastructure led to rapid export growth and industrialization. China has become so successful that it is now the largest trading nation and the second largest economy in the world.

The labor surplus is clearly gone. Indeed, the shortage of blue-collar labor is plaguing many industries. The wage for blue collar labor is rising at a double digit rate. In some industries like mining, it has doubled in the past three years. The wage level, however, is still one tenth of that in the developed economies. Cost isn't a barrier to China's industrialization yet. Upgrading is the right response to the labor shortage. In particular China must compete against Germany and Japan in the coming decade.

As China's surplus labor becomes fully integrated into the global economy, the country has migrated from capital shortage to surplus. China's trade surplus is at $200-400 per capita. This level is relatively low by East Asian standard. It could rise by five times or more. But, because China is so much bigger than other East Asian countries, if its trade surplus per capital reaches that level, the aggregate surplus would be huge relative to the global economy.

For example, if China's trade surplus reaches $1,000 per capita, a modest amount by East Asia standard, the total would reach $1.4 trillion, bigger than all the fund raisings in the stock market in the whole world. How this amount of money is deployed will hugely affect the global economy.

From trade to finance


A country becomes a financial center because it has succeeded in becoming the trade center. London became the global financial center because the UK had overtaken other countries to be the largest in trading goods and services. The financial center moved to New York because the US replaced the UK as the top player in international trade. China is now the largest trading nation in the world. By 2020 China could dwarf anyone else in international trade, becoming twice as largest as the second largest. Could and should China become the global financial center? The answer to both is yes, I believe. If China doesn't take actions to do so, it would hurt itself and the global economy.

Finance followed trade because most of financial services were related to trade. And, profits were mostly derived from trade too. One could see the linkage by visiting Pingyao, the little town in Shanxi that dominated China's finance in the 19th century. It is a small and poor place bordering Mongolia. In the 19th century, the rise of the Russian Empire created a big market and a safe pathway for selling Chinese goods to it. The people in Pingyao had the advantage of bordering both worlds and could arbitrage the price difference between China and Russia. The profits from the trade and the need for trade finance turned Pingyao into a financial center. It later declined because the seabourn trade replaced the costly overland trade. China's financial center also migrated to Shanghai.

This story repeats on a large scale in the whole world. The United States didn't plot to supplant the UK to become the international financial center. It happened because the US replaced the UK as the biggest industrial power and trading nation. Finance just followed. The importance of the Wall Street is a consequence of the US's industrial success.

The most important economic development in the 21st century is China becoming the largest industrial nation. I have anticipated this for a long time. This is a consequence of globalization and China's cultural characteristics. The government has adopted supportive policies, i.e., not standing in the way. No other country is yet on the horizon to stop China's industrialization.

By one measurement-the industrial energy consumption China is already the biggest industrial economy in the world. The dollar value isn't there yet because Chinese goods are still cheap. China could raise prices to absorb the rising labor cost in this decade and still grow exports at above 10% per annum. By 2020 China could become twice as big as Germany in international trade.

The largest trading nation should become the global financial center. Some may argue that was in the past. Information technology has made where asset trading occurs irrelevant. Germany's plight today should remind everyone that, when the financial center and the source of money are disconnected, bad things happen to whoever has the money. Even though Germany amassed the biggest trade surplus in the past decade, its financial system was woefully underdeveloped and relied on London bankers to recycle its money into other countries. With the benefit of hindsight, it would be natural that the London bankers wanted to screw Germany, because they were paid to do so.

In a decade or two, Germany may become a poor country. When people look back then, they would conclude that its decline was due to the combination of a hyper competitive manufacturing sector and a woefully inadequate financial sector.

Foreign exchange reserves cannot substitute a financial center


China has avoided Germany's fate by sending its surplus capital into government bonds, especially the US treasuries. This 'all eggs-in-one basket' strategy has worked so far. The government bonds of the major economies have held up in value, even though their economies are in shambles. But, government bonds cannot sustain value if the underlying economies are in constant crisis. At some point, either the government debt level is too high or its tax revenue is too low. Their central banks would be forced to bail out their governments by printing money. China would get its money back, but in severely depreciated currencies. Unless China changes its strategy, it cannot avoid Germany's fate.

China's net foreign assets have risen by twice as fast as its trade surplus. The main reason is capital inflow, especially from overseas Chinese, to avoid a depreciating dollar. The Chinese government is essentially taking on the currency risk for the whole overseas Chinese community. If China loses its foreign exchane reserves, the government may become bankrupt, and the country's financial foundation is gone.

In addition to asset safety, China's 'all eggs-in-one basket strategy' is creating distortion in the global economy. The sharp divergence between stock and bond prices is mostly due to the concentration of money among institutions that just buy government bonds. China is part of the picture. The oil export countries have even more money in the market. The low price of stocks discourages companies to invest and hire workers. While this isn't the only factor, it is a significant one in causing the instability in the global economy.

If a country makes a lot of money, it must be responsible for allocating the money effectively and efficiently to help the global economy. Otherwise, it would be worse off for everyone. In the past decade, China is just one player among several that have amassed money but done a poor job in allocating it. In the next decade, China would dwarf anyone else in amassing money. But, if China couldn't allocate the money effectively, the whole world would blame China for their ills.

China must become the biggest global financial center


If China upgrades its industries successfully in response to its rising labor cost, as Japan did in the 1970s and Korea and Taiwan did in the 1990s, the country may increase its trade surplus to $1 trillion. The per capita level would still be a modest $715 by East Asia standard. The total, however, is above the total fund raisings in all the stock markets in the world. Unless the money is deployed efficiently, i.e., improving rather than impeding global growth, the global backlash would impede China's development, causing disasters for everyone.

An alternative to the trade surplus is running a massive asset bubble to exaggerate domestic demand. Japan did that in the 1980s. China is doing quite a bit now. Without the domestic asset bubble, China's trade surplus would be twice as big, I believe. Running a bubble just delays the inevitable and creates a financial crisis as the price. China's total property value, including work-in-progress and land banks, is already 5 times GDP. The bubble is about 100% above the sustainable level. The bubble can be bigger, twice as big, if the government tolerates it. When the bubble is big enough, the country will run trade deficit rather than surplus. But, it is artificial. When the bubble bursts, the currency gets devalued, the property value drops to 2.5 times GDP or less. It would lead to a huge trade surplus of above 10% of GDP. But, the world won't tolerate that. The resulting protectionism would shut down the global economy for everyone.

The only good way out is for China to develop a global financial center that would allocate China's trade surplus effectively and efficiently to boost global economic growth. If China can allocate its surplus capital into the global economy efficiently, it can continue to earn surpluses.

The international board is a downpayment


China has a highly developed manufacturing sector but a backward financial sector. The later is dominated by state ownership and caged by a closed capital account and a fixed exchange rate. The mismatch between the two is the source of so many problems in China. The pressing issue is that the global economy cannot wait for China to go about its own pace. Unless China could allocate its surplus capital effectively and efficiently into the global economy soon, a global backlash against China's development is likely to emerge.

To develop a financial center, a country must have the rule of law, the strong protection for private property, and transparency. China lacks all three. It will take a long time to develop them. But, a downpayment in the form of an international board at China's Stock Exchange could help to jump-start the process.

The multinational companies need to expand in emerging economies. Their home countries don't have money surplus anymore. It makes sense for them to raise money in emerging economies for investments in them. While the market may start small, it would boost confidence among MNC's for future financing. They may become more willing to invest.

China should lay down the rules for the global top 500 hundred companies all to list in China. It should be a transparent process that won't require the aspiring companies to lobby the government individually. If the process is too tightly controlled, it won't have the impact on business confidence.

Many argue that the international board will weigh down the A-share market. This is just a petty excuse. The A-share market is already very low, because it is concerned about the growth at home and abroad. The international board will help the global economy. It would be good for China's economy too. The A-share market may rally on improving confidence.

To boost demand for stocks, the government could introduce new sources of demand. A 401K like retirement plan, for example, could boost stock demand greatly, possibly by over Rmb100 billion per annum. That would be sufficient to offset the fund raisings in the international board. Raising the stock investment ratio for insurance companies would be another source of demand. In short, there are many ways to increase demand to offset the fund needs of the international board. China runs a large trade surplus. Liquidity shouldn't be a problem. Appropriate policy adjustments can keep the liquidity for stock market.

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