If You Build It, Will They Come?

We left yesterday’s discussion pondering whether a weak US dollar and a policy of inflationism (apparently that’s a word) is deflationary for countries like Australia. Because Australia doesn’t actively manage its exchange rate, it absorbs US-induced inflation via a stronger dollar.

A stronger dollar represents an increase in Australia’s international purchasing power. The flip side is that other nations’ purchasing power is diminished when it comes to buying our goods and services. As a result, we suffer from weaker demand.

But the impact of China throws a big spanner in the works of this theory.

China’s booming economic growth is one reason why our dollar is so strong. For many international investors, the Aussie dollar is a proxy for China’s growth.

And it’s because of China the RBA is concerned about inflation. China’s unprecedented credit boom has sent Australia’s terms of trade to a record high. This had the effect of boosting nominal income growth (which is basically economic growth measured in current prices) to a peak of around 10 per cent in the June 2010 quarter. Such strong growth in national income is what forced the RBA to raise interest rates throughout 2009 and 2010.

And in the March quarter Australia’s nominal income growth was still around 7 per cent. This is why the RBA is still thinking about tightening (even though the bond market disagrees, more on that below).

Australia received a boost earlier this week on news that China’s economic growth for the three months to June came in above estimates, at 9.5 per cent. It gave the bulls something to crow about. ‘See, China is still booming, what’s there to worry about?’

Sure, 9.5 per cent economic growth is great, especially when most of the developed world is grovelling along at about 2 per cent. But let’s step back a moment and take a look at what’s driving that growth. It’s not a pretty sight.

Firstly, consider that inflation is running at an annual rate of 6.4 per cent. And following the latest rate rise in early July, the official lending rate is 6.56 per cent, while deposit rates languish at 3.5 per cent. So real interest rates (nominal minus inflation) are barely positive, providing a massive incentive to borrow. When you have economic growth running at 9.5 per cent, China’s interest rates are nowhere near ‘tight’.

Which is why economic growth is still firing. Despite attempts by the government to cool speculation in the real estate sector, activity there remains decidedly hot. According to the National Bureau of Statistics of China, in the first half of 2011, investment in real estate development jumped 32.9 per cent year on year. Of this, investment in residential buildings was up 36.1 per cent.

In an attempt to curb real estate investment, the government has ordered the banks to pare back their lending to the sector. But, as happens when you have a bunch of profit maximising individuals running around, they often outsmart the regulators.

Over the past year or so, a new form of financing has surfaced in China. Local governments have started issuing bonds with future land sales acting as collateral for the loan.

A recent Bloomberg article tells the story of the city of Loudi, which is undergoing massive development. This reflects the current mentality in China, ‘build it and they will come’.

‘Workers toil by night lights with hoes, carving out the signs for Olympic rings in front of an unfinished 30,000-seat stadium, bulb-shaped gymnasium and swimming complex in a little-known Chinese city.

‘Loudi, home to 4 million people in Chairman Mao Zedong’s home province of Hunan, is paying for the project with 1.2 billion yuan ($185 million) in bonds, guaranteed by land valued at $1.5 million an acre. That’s about the same as prices in Winnetka, a Chicago suburb that is one of the richest U.S. towns, where the average household earns more than $250,000 a year.

‘In Loudi, people take home $2,323 annually and there are no Olympics here on any calendar.’

Moody’s ratings agency reckons local government loans total around 14 trillion yuan, which is well above official estimates of 10.7 trillion yuan. Whatever – if the majority of these loans are backed by inflated property prices then there is trouble ahead for China’s asset and property boom.

The source of the problem here is, as always, easy money. When there is excess money floating around an economy, ridiculous deals will always get off the ground.

In China’s case, the source of the problem is a manipulated currency.

In order to keep it’s currency pegged to the US dollar, China must print yuan to offset trade surpluses, interest income and ‘hot money’ investment flows.

On the asset side of the ledger, China builds foreign reserves – it now has around US$3.2 trillion worth. That’s what everyone focuses on and thinks is one of China’s great strengths. But there must be liabilities to offset the assets. And these liabilities are newly printed yuan, which sit as reserves in the domestic banking system.

And as you know, bank reserves are the fuel needed for fractional reserve banking to wreak its inflationary havoc. This is pretty much what is happening now.

A big part of the problem in China is that, like in the West, lending is done with little consideration for risk. People think the government will bail them out if things go wrong.

And most analysts take a sanguine view of China’s problems. They think that China can just recapitalise its banking system using their vast foreign reserves.

Well they can. But at a rather large cost.

If China Inc. wants to mobilise reserves for domestic purposes, it must sell some of its foreign assets… say US treasury bonds. To shrink its assets it must also shrink its liabilities. Doing so would represent a form of monetary tightening, as domestic bank reserves would decline. But then China would need to buy more yuan to recapitalise the banks or bail out dumb lenders, so its currency (all other things being equal, of course) would rise.

When China’s fixed-asset/property bubble bursts, it will have no easy choices to repair the damage. Sure it has plenty of reserves. But the accumulation of these reserves reflects very easy monetary policy. So slowing of reserve growth or even reversal would constitute a tightening.

How far away are we from seeing a more marked slowdown in China?

Maybe not too far.

While foreign exchange purchases by the central bank were still US$153bn in the June quarter, the inflow for June was 26 per cent below the level of May.

And while headline GDP growth for the June quarter may have been 9.5 per cent, second quarter growth was 2.2 per cent – or 8.8 per cent annualised.

Just as easy money feeds on itself to create a frenzy of activity, its reversal can have devastating consequences, as you saw with the US housing market a few months ago.

China is not the pillar of strength it is made out to be.

The Aussie bond market seems to agree. It now thinks the next move in interest rates will be down. Without the benefits of the China boom, Australia may face a deflationary future.


Greg Canavan
Markets and Money Australia

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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Thanks Greg. I’m hoping this China Oz relationship keeps plugging along. However there must be much more to this story we’ve considered maybe. How China has kept on keeping on with consumption down in the west and with its over-investment in property, rampant inflation etc etc I don’t know but it just has. Keep on digging then Greg. Cheers

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