The Next Bubble in China’s Economy

We’ve battled this argument before, so we apologise if we repeat ourselves. But it needs to be said because the mainstream media continues to talk gibberish about China’s economy.

This is the argument: a falling inflation rate in China allows the authorities to ease monetary policy to avert a hard landing. Or, as today’s Financial Review puts it:

China’s government has been given room to ease credit policy further to bolster growth in the world’s second largest economy after inflation fell to a yearly pace of 4.1 per cent in December.

The fall in the consumer price index from 4.2 per cent in November, down from a 37-month high of 6.5 per cent in July, is likely to increase Beijing’s confidence that inflationary pressures are being brought under control while policymakers look to provide additional support to the economy as export demand slows and the housing market turns down.

This simplistic view fails to take into account complex monetary mechanisms of China’s economy. Firstly, China pegs its currency, the yuan, to the US dollar. And because China’s economy runs a trade surplus with the US, it ends up with excess US dollars. To maintain the peg and stop the yuan from appreciating, the People’s Bank of China (PBoC) must print yuan to buy these excess dollars.

The dollars make their way into the vaults of the PBoC (and are known as foreign exchange ‘FX’ reserves) while the yuan make their way into the domestic banking system.

So, the build up in FX reserves matches the build-up in the reserves of the domestic banking system. The more reserves a bank has, the greater its lending power.

This is inflationary. And when the government encourages its banks to lend without discrimination, you tend to get things like property bubbles forming. In an attempt to offset this wildly inflationary impact, the PBoC raised reserve requirements.

But here’s the point. Placing a higher reserve requirement on the banks was not an example of monetary policy ‘tightening’. It was merely a way to try and neutralise the impact of an expanding FX account.

Recently, the PBoC began to lower the reserve requirement. According to most analysts, this represents an easing of monetary policy. But we disagree.

Let us explain why…

China’s huge FX reserves are no longer growing. In fact, they are widely tipped to have contracted in the final quarter of 2011. Sensing the party is over, speculative money is quietly flowing back out of China’s economy. As FX reserves fall, so do banking system reserves. Left unchecked, this represents monetary policy tightening. A lower reserve requirement merely offsets the effect of falling FX reserves.

That’s all pretty technical. If you’re still following, we’ve got a much simpler reason why looser credit policies won’t work in China – a lack of demand. Banks can supply all the credit they want. But unless there’s a willing borrower, it’s useless. Ask Ben Bernanke.

When a bubble bursts, as the property market in China has, the effect is financial and psychological. The emotion of greed (which fuels demand for credit) wanes. Fear (which restricts the flow of credit) takes over.

China’s policy makers will now attempt to do what just about every policymaker since the South Sea bubble has done – reinflate. But as history has shown, you can’t reinflate the same bubble. You just create others.

Where will China’s next bubble appear? Hmmm…how about gold?

China’s imports of physical gold via Hong Kong have soared in recent months, as the following chart from Reuters shows. In November alone, gold imports totalled nearly 103,000 kg.

Are Chinese citizens trying to protect themselves from falling property and equity markets? With deposit rates less than the inflation rate, there’s no respite by placing funds in the banks either. Gold seems like a sensible option.

And judging by the volume of imports, there’s a good chance the PBoC is in there buying too.

China's gold imports from Hong Kong

Just where is all this gold coming from? Our guess is Western central banks. In an attempt to keep the gold price quiet during the euro storm in the later half of 2011, we reckon Western central banks dumped gold onto the market.

China merely took advantage of this stupidity.

But gold is not just going to be the next bubble in China. It will be international in scope.

President Obama has just asked Congress to raise the US debt ceiling, again, by US$1.2 trillion – to US$16.394 trillion. It’s getting monotonous. You can’t create gold at anywhere near the same rate or ease. The result? Gold will rise against all currencies.

Which brings us to the euro. Overnight, both Spain and Italy enjoyed successful bond auctions – courtesy of Mario Draghi, head of the European Central Bank. This is one deceptive bloke. While talking tough on the ECB’s mandate not to finance sovereign nations, he’s gone and done it anyway.

The ECB recently changed the rules on acceptable collateral. Europe’s impaired banks can now hand the ECB the lowest, illiquid asset on their books. And the ECB will give them cash in return.

The banks can then use this cash to buy high-yielding sovereign debt, which they are clearly doing. The ‘spread’ – the difference between the cost of funds and the yield on the purchased debt – is huge, meaning a windfall for the banks.

This is a huge ponzi scheme and will end like all the others. It’s just a matter of time. That’s why Greece remains so important. If Greece defaults, the ponzi is over. The hedge funds (from yesterday’s discussion on Greek debt ) know this and are rightly betting on Greece getting another bailout package.

But who’s really getting bailed out? A large portion of the money due to Greece from the IMF simply goes to repaying existing debt holders – the majority of which are hedge funds. The term ‘bailout’ is Orwellian. The IMF and EU are really providing Greece with ‘Default Deferral Funds’.

The system is a mess. Attempts to fix it are only causing deepening long- term problems.


Greg Canavan
for Markets and Money

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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4 Comments on "The Next Bubble in China’s Economy"

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I’m not sure Greg. In the west demand pull inflation was extinguished as private credit hit saturation point and could no longer be generated fast enough to raise asset prices. In China and closely following your description of events, reserve requirements were raised prior to a natural climax in credit demand ie deliberately in order to curb asset price inflation…. “In an attempt to offset this wildly inflationary impact, the PBoC raised reserve requirements”. Your point about psychology affecting inflation going forward I can see however we are left technically with a clear potential for monetary policy to reignite credit… Read more »

Definitely sharp business cycles as we see now and even somewhat worse…but I doubt a protracted problem for China like I bet on for some western economies eg likley decade/s long event for USA.


Keep an eye on steel production in China as this has been the key to their economic growth over the last 20 years. If steel production turns down then I believe there economy will contract. Most of the steel is used in construction and if their real estate has become over valued there will be a bust at some point.


Why would domestic bank reserves fall when fx reserves decrease? They have already been created and do not just disappear.

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