China’s coming magnificent bubble
If and when China makes its currency convertible and opens its financial system the stage will be set for a bubble that should make the dotcom and housing booms look tame.
China has recently signaled its key aspirations: for a greater international role for the renminbi and for Shanghai to become a great financial capital. Neither is imminent, but both imply, if not require, a series of steps that, taken in combination with China’s legitimately great potential for growth, could lead to a bubble of magnificent and dangerous proportions.
Magnificent in that, like the dotcom bubble or the railroad boom in the U.S. in the 19th century, a bubble in domestic China is directionally right and will build useful things which will change the world. A bubble, after all, needs a good story and China has one of the best ever.
Dangerous because, like the housing bubble, it will inevitably go too far and could take down banks and banking systems globally.
Perhaps rather than dotcom or housing, the most useful template for China is closer to home; namely the Japanese bubble which preceded its ongoing malaise, according to Dylan Grice, a strategist at Societe Generale in London.
“In the medium term we face the mother of all asset bubbles in China. The fundamental story is a good one; there are just lots and lots of people to sell to,” Grice said.
“If you drop a ton of liquidity on people it is possible that they will do rational things with it, but more likely they will do something pretty stupid.”
The parallels are strong. Both China and Japan successfully industrialized and opted for high-savings, low-consumption economies which concentrated on exports, exporting capital and keeping their currencies artificially weak. The result in both cases was a huge stockpile of U.S. Treasuries.
Both, too, scared their western clients and competitors witless. Remember U.S. autoworkers ritually burning Japanese cars? This of course was mingled with admiration and a sense that the global balance of power was changing, giving bubble thinking a strong push.
Japan slowly and over a long period liberalized its capital account; allowing the yen to float freely and deregulating financial markets.
Grice points out that during some of the 1980s the world fell in love with the yen, figuring that Japan’s new ascendancy meant that it would rise and rise. As a result Japan Inc. could in effect borrow in dollars, swap it into yen and get paid for the privilege. Much of the money found its way into the stock market, sending stocks to stratospheric levels and reinforcing the bubble illusion.
The Nikkei index of stocks went to the moon and Tokyo residents ended up needing 100-year mortgages to afford tiny apartments.
GOOD AND BAD BUBBLES
Of course, that is not where it ended with Japan, which had its bust and which is still struggling with deflation, though that is in part a function of a shrinking workforce.
Japan liberalized its financial system and currency arrangements under strong pressure from the United States.
China almost certainly has more relative real power today and there is every sign that it will open up on its own terms and to its own schedule.
But open it probably will.
Chinese officials have expressed a desire for the renminbi to play a great role in world trade, naming 2020 as a date by which it can play the role of a reserve currency.
That is almost certainly going to require deregulation of financial markets, something also needed if Shanghai is to become a global financial capital.
China now buys Treasuries not because it thinks they are good value, but because those purchases maintain a competitive currency, not to mention protecting existing holdings. As that ends, much of the money will seek out high returns, and as the renminbi strengthens international capital will doubtless pile on and pile in.
That kind of liquidity and deregulation, in combination with strong national pride and a legitimately fantastic story, is a step-by-step recipe for a bubble. So it proved in Japan, so it likely will be in China.
A look at recent experience in China only underlines this. Speculation is rife and billions in government mandated loans have leaked into stock market bets.
China’s government undoubtedly understands all of this and is surely determined to maintain control. They may not find it that easy. Getting rich, as we’ve seen in the United States, is a heady business and it is easy to start to believe your own press.
As the momentum builds and the money rolls in it will be easy to see it as a great country meeting its prosperous destiny.
Given the size of the opportunity and the strength of the story, China’s bubble will be huge. Investors would do well to avoid being in the immediate vicinity when it bursts.
–At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–