Inflation & Bubbles – THE issues of 2011?

6 Dec

Could a bubble in Chinese real estate, and Chinese inflation be THE issue for global markets in 2011?…

“Many see China’s monetary tightening as a pre-emptive tap on the brakes, a warning shot across the proverbial economic bows. We see it as a potentially more malevolent reactive day of reckoning”. This is a quote from a report by Tim Ash, head of Emerging Markets at RBS.

In fact RBS go further, and recommend CDS’s on China’s five-year debt. They do not forecast a default mind you, but make the recommendation as insurance against the “fat tail risk” of a hard landing, with potential consequences across Asia.

We’ve all seen the recent inflation news coming out of China. Official figures put inflation at 4.4% in October and 5% last month. However, with the price of veggies increasing around 20% last month, you’d be hard pressed to find anyone who totally accepts the official numbers.

Now Chinese rulers learned about the dissent caused by inflation during Tianamen in 1989. Once again, in the words of RBS: “Inflation is a redistributive mechanism in favour of the few that can protect living standards, against the large majority who cannot. The political leadership cannot, will not, take risks in that regard.”

As the West melted, China stoked a massive credit boom in an attempt to keep huge growth. The policy has clearly been a success from that perspective. However, increases in credit have led to speculation and price spirals, most notably in real estate. House prices in Beijing are 22x disposable income, and 18x in Shenzen. The US bubble peaked at 6.4x, and has now dropped to 4.7x. Clearly the housing market is coming disconnected from the fundamentals. With data points like this, perhaps though I should just come out and call it what it is: A bubble. As I’ve written in the past – all bubbles must burst.

Recently the IMF pointed out that land sales account for 30% of local government revenues in Beijing. In the long-term fundamentals and prices always coincide. With that in mind I am also concerned about a hole in local government finances once state property taxes begin to wane.

Once the fundamentals gain control, Chinese growth is going to suffer, as private credit in China has reached 148% of GDP compared with 41% for EM overall (though they note that the scale of loans to local governments and state entities is not easy to discern, and the scale of overall credit might be higher).  Fitch and Oxford University have conducted a joint study on the outcomes of Chinese growth falling to 5% (i.e. a de facto recession). They conclude that global commodities would fall by 20%, emerging Asia growth would fall by 2.6%, spreads on EM debt would widen to about 100 points, and Asian stock exchanges could fall 25%. Add to that the risk of political instability. Doesn’t sound pretty!

There’s clearly an issue, and the question is whether the one-party central government has the power to solve it. I am sceptical that they can solve the problem entirely. Firstly, the use of their reserves for internal usage is limited (as was the case when the US had such high reserves as a % of GDP in the 20’s and Japan in the 80’s). Secondly, the warning signs now show that they over estimated their power to control the economy on the other side of pumping out all this credit. This does not mean however, that they are incapable of averting a total disaster.


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