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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory

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From: russwinter3/24/2005 8:43:34 PM
   of 110189
Nouriel Roubini:

March 23, 2005
China Impressions..and Surprises...
My colleague Brad Setser summarized real well our first impressions of China; we will write soon a longer trip report/paper. Let me elaborate now briefly on a few points.

While the political leadership is saying - at least officially - (and Roach has confirmed their alleged views) that a cooling off of the economy is occurring and that the restrictions imposed in 2004 are working, the reality is quite different; most Chinese economists and policy officials one step below the top political leadership are expressing some serious concerns with the imbalances in the economy.

Indeed, foreign exchange reserves accumulation is still very rapid and only a fraction of it is sterilized; thus, base money is growing rapidly and administrative controls have had limited effect on curbing the loan and credit growth and the asset bubbles in the economy. So, the construction boom and property price bubble is continuing unabated and investment growth is still faster than nominal GDP growth (23% growth in fixed investment in Jan-Feb); so, investment as a share of GDP - already close to 45% - is increasing further. Thus, the overheating of the economy is continuing at a rapid pace; maybe, not as rapid as in early 2004 but still overheating and showing little signs of a soft landing or any landing at all. Also, inflationary pressures are lurking back while the official inflation rate is still being in many ways repressed via administrative controls of prices. Further, the banking and financial system is still in shambles and the latest China Construction Bank (CCB) scandal - with the head recently stepping down for alleged corruption - signals that the financial system has still very serious problems. And $45b of recap funds for the two big banks is very little compared to NPLs that are likely to be 70% of GDP for the overall financial system; and these NPL will grow as many loans will go bust once the investment boom goes bust. Indeed, the CCB scandal and other evidence of systematic corruption and malfeasance throughout the banking system shows how the banking system is still significantly rotten and fragile.

Also, in China, investment as a share of GDP has averaged historically around 30-35%; when it spiked above 40% in the mid 1990s, it went bust with a hard landing of high inflation and low growth in the mid-late 1990s. A similar risk is emerging now with investment still growing too fast. In many ways, China looks like East Asia in the mid-1990s before the crisis of 1997-98: a country where connected and directed lending, poor corporate governance and severe political interference (especially at the provincial level) in the credit allocation system is leading to many distorted and low return investment projects that will eventually go bust with a serious crisis. Of course, this potential Chinese hard landing crisis will not take the form of an external payments crisis as it did in East Asia: China, differently from East Asia in 1997-98, has large amounts of foreign reserves, low short term external debt (while growing), a current account surplus and capital controls. Still, an economic hard landing will take the form of a domestic financial crisis with massive real, financial and fiscal costs (once the true recapitalization of the financial system has to be done rather than being shoved under the rug as it is now).

Moreover, admnistrative controls, such as those imposed in 2004, are leaky and not working properly as the recent re-acceleration of investment, construction and retail sales shows. Central to all these imbalances and risks is an overvalued currency that is fueling monetary creation, easy money conditions, inflation risks, excessive capital inflows and the persistence of the economic excesses and bubbles. Most economists and folks at MoF and PBoC are aware of this and some are expressing serious doubts about this economic model based on high export growth and reserve accumulation that are feeding the financial and real excesses. They would rather have a significant appreciation soon that, appropriately managed, would work much better than distortionary administrative and non-price based contraints as a tool to cool off the economy.

Also, while the convential argument and wisdom is that China needs to maintain its peg as it is the essential source of export grwoth that will absorb every year millions of rural workers moving to urban areas, many in China - even at the most senior level - are now rethinking the growth model based on external demand, net exports and large amounts of FDI. This model is leading to many severe imbalances: regional ones between fast growing coastal areas and inland China, distributional ones between rich and poor, sectoral ones with export sectors and construction booming and other public and private services being mediocre, financial ones with hot money in, monetary and credit controls out of line and forex reserve accumulation that is excessive and potentially liable to massive capital losses.

A similar assessment of the vulnerabilities and risks and imbalances of China was recently expressed at the most senior level by Guo Shuqing, the former director of the State Administration of Foreign Exchange (and vice-governor of the central bank) and now the chosen new head of CCB. As reported by the China Daily he expressed views that are quite similar to those that Brad and I (see also here) have been expressing for a while:

A top central banker called for strong measures to adjust China's foreign trade and investment policies to control the downsides of unbridled growth.

"Indiscriminate support of exports and foreign capital influx has created short-term economic problems, including excessive speculation in the property market and the economic decoupling of the fast-growing coastal areas with the rest of China," Guo Shuqing, director of the State Administration of Foreign Exchange (SAFE), said in an interview with China Daily.

On Friday, Guo was named candidate chairman of the China Construction Bank Ltd Co after the bank's former chairman Zhang Enzhao resigned earlier last week.

Guo's comments come at a time when the government is vigorously pursuing a "scientific approach" to achieve sustained development and are all the more significant because it indicates the government's resolve in addressing the fundamental issues being discussed among top economic policy makers.

Economists have long been calling for a shift in emphasis to facilitate the transformation of China from a low-cost manufacturing base to a world industrial power.

"We should gradually reduce the preferential treatment to exports and seriously review our foreign investment policy," Guo said.

Excessively favourable policies towards exports and foreign investments made sense in the years immediately after the country adopted its "opening-up" policy in 1979, he said.

But over time, such policies have fostered the erroneous belief that has led to the unconditional support for foreign investment and exports to achieve a consistent trade surplus.

"This mentality should be corrected," said Guo, an economist who used to be in the central government's bodies for economic restructuring.

He said exports should not be given a superior position in the country's economic development agenda than imports.

"And trade surplus is not necessarily a good thing all the time," he said.

China's exports contributed much to the coastal area's prosperity.

However, after so many years, exports with relatively higher added-value, especially those with Chinese-owned intellectual property rights, account for a persistently low proportion of total exports, he said.

"This kind of export growth is not sustainable," he said.

Meanwhile, a relatively conservative approach to imports has the effect of discouraging domestic manufacturers from upgrading their production facilities with imported equipment and technology, Guo said.

Policies towards foreign investments have shared some of the same shortcomings with that of trade. As a result, a host of explicit and implicit advantages have been introduced overtime for foreign-invested enterprises.

The foreign-related segment of the economy, which constitute key parts for the economy in coastal areas, has gradually drifted away from the rest of domestic economy. These foreign-funded enterprises have more transactions within itself and with foreign economies than with domestic firms.

Many foreign-funded enterprises are actually a link in the industrial chain that also include the United States, Japan, and other East Asian economies.

"More than half of China's exports and overwhelming majority of high-tech manufacturing and trade are generated by foreign companies," Guo noted.

This contributed to the regional imbalances between coastal areas and the inlands, he said.

Unchecked increases in exports and foreign investment are also partly responsible for China's trade surplus and colossal foreign exchange reserves.

Apart from their well-known merits safeguarding the country from financial crisis being the most well known huge reserves can cause problems. "For one, it reduces the independence of the country's monetary policy," said Guo, who also serves as a deputy-governor of the People's Bank of China, the central bank.

During the past few years, the central bank has bought the huge foreign currency holdings of commercial banks, which is the result of the trade surplus and investment inflow. To buy in the foreign currency, the central bank has to release huge amounts of renminbi.

This conflicts with the central bank's agenda of controlling the increase of money supply.

The country's trade surplus and huge reserves actually reflect imbalance structure of domestic economy, which need a holistic cure.

"China needs a strategy for more of a balanced development," Guo said.

He said the country should reduce energy-consuming exports and exports of resources China is short of. It should also control exports of generic manufacturing goods. At the same time, the country should urge developed countries to relax restrictions on their technology exports to China and improve quality of China's imports, he said.

As to investment, policies for domestic and foreign enterprises should be unified. Restrictions should be imposed on foreign investments in industries that use low-level technology but generate high pollution; on those that produce products oversupplied in both domestic and international markets; and on investments that are easy to lead to speculative activities and property bubbles, he said.

According to Guo, the latest sign of unwanted foreign investments is seen in the real estate and financial markets.

He said SAFE officials have spotted foreign funds that entered China disguised as money for trade or direct investment purposes but ended up being used to buy renminbi-based financial assets and property.

"We found the phenomenon of one single (overseas) person buying up to 100 houses in coastal cities," he said.

"This is apparently speculative activity," he said.

The speculators were betting on an appreciating renminbi. Their massive purchase of houses have contributed to the surging housing prices in coastal areas.

So, Guo Shuqing was in charge until a week ago of managing $600 billion dollar plus of foreign exchange reserves and also in charge of altogether leaky capital controls (as "hot money" inflows last year were as high as the current account surplus plus the FDI inflows leading to a $200 billion accumulation of new forex reserves); now he will be in charge of cleaning up one of the biggest public bank (China Construction Bank) that was supposed to have its IPO later this year but whose former head was fired last week for corruption (thus showing a financial mess that is larger than previously revealed and that will lead to the certain indefinite posponement of such IPO).

So, someone as senior as Guo Shuqing claims that the current Chinese growth model is severely imbalanced and in need for a radical change. The top leaders in the State Council, conservative and cautious as they are, may not be ready yet to change the growth model or to move the peg. But, like Guo, many other Chinese economists and officials at the central bank and finance ministy level, are starting to express similar concerns to higher authorities. And the authorities are listening carefully. This debate and reassessment of the Chinese growth model and its foundation on a fixed rate regime is novel and that is what leads me to argue, in spite of what Roach suggests, that the Chinese may move their peg sooner than currently expected. Afterall, even the Premier Wen Jiabao - as reported by Roach: shook his head and exclaimed, “I cannot sleep well at night with this issue of the RMB.”

And dreams - hopefully not nightmares - of currency regime change may "unexpectedly" occur in the minds of such leaders. Indeed, Wen Jiabao recently warned:

"Our goal has been to let market supply and demand determine the exchange rate...We are carrying out such work now, and as for the timing and what measures will be adopted, this could be unexpected."

So, be ready to be surprised this year...
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