ôEquity can be a bit thick. It doesnÆt understand whatÆs going on in the credit space,ö is the way leading CLSA commentator Christopher Woods explained the paradox at the recent Hong Kong CLSA Forum.
It increasingly looks as if Woods is right, and heÆs not the only one to think that it is absurd to believe that one form of capital won't impact another form of capital. After all, they are both forms of money. And bad money always ends up driving out good money.
Richard Duncan, a noted author on the dollar crisis, has argued that the reason growth has exploded over the past several years is essentially due to liquidity creation in countries like China. Many countries create liquidity, but few do it on the scale of China.
ChinaÆs forex reserves recently overtook those of JapanÆs. They are now almost one and a half times as large. (Other central banks playing the same game have also contributed, but the two main players are China and Japan. Of the total global foreign exchange reserves of $6 trillion, China has $1.4 trillion and Japan has just under one trillion). $6 trillion amounts to half of AmericaÆs GDP. ItÆs also a sum which is then itself subject to further credit creation in the banks and hedge funds it passes through. ItÆs hard to calculate how much, although Marc Faber, author of the Gloom, Boom and Doom Report, estimates total credit markets amount to over $36 trillion in the US û an impressive figure.
Contrary to what many people think, those forex reserves are not signs of strength. On the contrary, the foreign exchange reserves exist because the Chinese government creates them. What does that mean? If you take a transaction between China and the rest of the world, the foreign partner will pay Chinese exporters in US dollars, which are repatriated in renminbi. Yes, that means that the Chinese exporter does not want US dollars, since heÆs Chinese and needs to pay his workers in renminbi.
However, the act of changing the US dollar into renminbi would normally push up the value of the renminbi. Consequently, the Chinese central bank steps in and creates renminbi in return for the foreign currency that has been sold by the Chinese exporter. That has two effects. It pushes the value of the renminbi lower, by increasing the supply of renminbi. And of course, it increases the supply of renminbi since thatÆs what the central bank is creating via its acquisition. The crucial thing to remember is that the Chinese central bank is creating money (literally out of thin air) to buy the foreign exchange. All the other central banks are doing the same thing, of course.
ItÆs implicit in this argument that the root of all our problems is not in the US at all (unlike the scathing criticism that commentators such as Marc Faber have unleashed on the US). The liquidity that has driven growth both in China and the rest of the world originates in the extra cash that the Chinese central bank has created to buy the forex to protect the low value of its currency.
Now, if China has been a huge liquidity creator, much of which has been absorbed by the US, it goes without saying that China is inextricably linked to the problems in the US. This is, by definition, not a problem that can be solved by the fashionable term of ædecoupling.Æ Yes, there has been some decoupling of Chinese exports to the US. But itÆs not in the real economy that the problem lies. The true problem lies in the almost $1.3 trillion (expected to be $2 trillion next year) of mainly dollar-denominated reserves which China has. ItÆs that $1.3 trillion, lent primarily to the US government, which has been pumped through US economy, driving down the cost of capital and stimulation expansion. Even those funds which are invested mainly in treasury bonds encourage bubbles because of what Duncan calls the æcrowding outÆ effect of so much money being invested in ultra-safe government bonds. That pushes other peopleÆs money into riskier areas û such as the elaborate financial concoctions that have caused so much trouble to Bear Stearns, Merrill Lynch, Citi and the latest casualty Morgan Stanley.
Is this to say that China is somehow the æbad guyÆ in all this? Not really, at least on the evidence so far. The US has permitted itself to be hooked onto Chinese credits because of the ædollar standardÆ. The dollar standard refers to the current US currency regime where no backstop exists to US borrowing. Under the Bretton-Woods system, the US dollar was only permitted to fluctuate within a narrow band against other currencies. In other words, the currency could not be weakened (by excessive borrowing) or strengthened (through an excess of exports over imports or other mercantilist policies). That meant the governmentÆs fiscal options were automatically limited. That changed when Republican president Richard Nixon freed the dollar from its trading ranges in the 1970s. That, in turn, freed the government from any limits on its fiscal policy and helped it pay for the Vietnam War and its aftermath.
The result of the dollar standard is that has enabled the US to run up huge debts to pay for Chinese imports. In an important sense, China is not the instigator of liquidity in the equation. China cannot force US consumers to buy its products (which in many cases are exported by US companies anyway). But by being ready to create money, artificially cheapen its products and lend to Americans (and other countries) China has enabled that process of indebtedness. ItÆs a combination of circumstances, whereby the US has a fiscal system which permits unlimited borrowing and an emerging power which has an incentive to run an export-based based manufacturing economy. It takes two to tango.
Jim Walker, CLSAÆs chief economist, also believes that any talk of China decoupling from the crisis gripping the rest of the world economy is wistful thinking. ôChinaÆs industrial structure has been extended on cheap credit, a mis-priced exchange rate and artificially strong external demand,ö he writes û with that artificial demand coming in the form of the Chinese central bank creating money which it then recycles for the US to use. No wonder growth can continue so strongly in China û the government is avoiding creating domestic inflation at home by focussing on investment-lead growth, while stimulating inflation, consumption (and debt) in the US and other places. Excess debt is a form of inflation, since it raises the ratio of liquidity to assets.
It would be much healthier û although much slower û for China to limit its exports to what its creditors can truly afford. When the great credit bubble does start to unwind, China will inevitably be left with massive spare capacity. That will of course lead to massively non-performing loans and a huge spike in unemployment. Real estate and stock markets will collapse.
As an alternative, the Chinese government will hope to switch demand drivers to its own population. That would encourage a more balanced economic model favouring the countryside û if only because tapping the countryside is the easiest way to stimulate new sources of demand. If China re-pegs its currency to stimulate its consumers and pay less for imports, the result would also be an acceleration of ChinaÆs GDP growth in dollar terms. So ironically, a disaster in the US could lead to a better-balanced and stronger Chinese economy. ItÆs not clear whether a catastrophic recession is a price the US is willing to pay for that happy outcome, though.
This story first appeared in the November issue of FinanceAsia magazine.
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