James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

There are signs that China’s stupendous debt-fueled boom is cooling, posing new risks for global growth and markets.

The People’s Bank of China on Thursday raised the bank reserve requirement ratio to a record 21 percent, a rise of a half a percentage point and the fifth so far this year. The move, effectively a tightening of monetary policy, comes as inflation at 5.3 percent remains high and industrial output slides, albeit to a still high 13.4 percent in the year to April.

China is an economy addicted to investment, a sort of fun house mirror of the U.S.’s addiction to consumption, with an astounding 93 percent of GDP growth in 2009 attributable to investment.

That’s a strategy that worked well for years, but China’s response to the global financial crisis, a sort of all-in push for lending and investment, has led to over-heating, uneconomic projects and possibly now a disruptive slowing of growth.

An estimate by Lombard Street Research of broad money growth, including various banking shenanigans, showed growth equal to 40 percent of GDP in 2010, but falling quickly to 23 percent of GDP in the first quarter. Those figures reflect the tremendous growth of money being pushed through the banking system and through a shadow banking system that grew rapidly last year as banks tried to evade government control. The slowdown is almost as striking as the still heady heights of the growth.

That money powered investment across China into infrastructure, industrial production and real estate, sucking as it did tremendous amounts of raw materials and industrial goods from elsewhere in the world.

If Chinese appetite cools, the effects elsewhere will be large, both in countries like Germany which supply goods and places like Australia which supply materials.

There are complex opposing forces in China, with the central bank applying the brakes but other government authorities deeply ambivalent about the implications of a slowdown in investment.

“Historically one of the key indicators that the high-growth investment-driven model has reached its limits as a wealth creator (i.e. is no longer allocating capital efficiently) is when we see an unsustainable increase in debt,” according to Michael Pettis, a professor of finance at Peking University.

“Of course whether or not we have reached this point is still much debated, but I would argue that we started to see this at least five years ago. The surge in banking assets doesn’t give much comfort.”

BANKING ASSETS HIT RECORD

Total assets in the Chinese banking system grew to 2.39 times Chinese GDP last year, yet another record, driven by heavy state-instigated lending beginning in 2009.

There are also reports of widespread off-balance-sheet maneuvers last year and this by would-be borrowers seeking to raise funds while avoiding official control. The asset figure is likely a large underestimate of both assets and of the stimulative effect debt is having on the economy.

The real problem with the end stages of a debt-financed growth binge is that policy makers are trapped regardless of what action they take. If Chinese authorities stamp on bank lending they are sure to leave many projects halfway completed and in default, a serious blow to an already shaky banking system. If, on the other hand, they allow loans to continue to be made freely we will be looking at much froth and many projects with highly uncertain economic underpinnings and value.

So, if the money actually is slowing what will be hurt? Chinese bank shares are already underperforming western peers, perhaps discounting the possibility of loans going bad if sky-high property prices sag. This looks a distinct possibility: housing sales were down 40 percent in Beijing in the first quarter.

Again, the risk here is that the banking system goes from overdrive to credit crunch if it sees and fears bad loans.

Analysts at Societe Generale suggest that hard commodities, such as copper and iron ore, would be particularly hard hit. If the slowdown is mild we would likely see only the most frothy markets hurt, but in the event of a hard landing, probably not a central scenario this year, the impact would be both big and global.

Longer term the question for China is how it dismounts from the tiger of an investment- and export-oriented economy and makes the transition to one with more domestic consumption. Letting the yuan rise strongly against the dollar would help. A large one-time revaluation of the yuan would also obviously help to control inflation and so might be a possibility.

Unless the transition to a more balanced economy is very gradual it will be disruptive. China, having helped to fuel a bubble in many assets, may well be the catalyst for the corresponding crash.

(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.)

Looking to hedge against a spike in inflation? Equities may not be much help.

Neither, for that matter, will you do all that well over the longer haul with bonds, cash or even commodities, at least on the historical evidence. In short, when it comes to investing, inflation is a real drag.

It’s impossible to know if, much less when, the current very stimulative monetary policy in the developed world will spur inflation, but increasingly indicators are raising concerns. Emerging market economies show signs of overheating, while prices of food and many other commodities are surging.

The traditional view has been that equities are an effective hedge against inflation, in least over the long term, because companies will, all things being equal, eventually pass on inflation to their clients as higher prices.

That’s the theory, but the practice may prove to be much different, according to a study by IMF economists Alexander Attie and Shaun Roache, who examined the performance of a range of traditional asset classes in the aftermath of inflation shocks.

“Among traditional asset classes, inflation hedges are imperfect at best and unlikely to work at worst,” according to Attie and Roache.

First, the authors looked at returns in the 12 months after inflation shocks in the period after the 1973 end of the Bretton Woods system of fixed currencies. The results were not surprising; bonds got killed, equities did badly, as did cash, while commodities were an effective hedge. Real estate investment trusts (REITs) did about as badly as equities, somewhat undermining the argument for real estate during inflationary periods.

All well and good, but really only of use for the small number of daredevils who are willing to make big asset allocation shifts over a short period of time.

For most savers, not to mention pension funds and endowments, the more useful question is how do you hedge against inflation for the longer term?

The results for equities were not encouraging.

“Equity returns decline in the months following an inflation shock and do not experience a meaningful recovery thereafter, leaving them as the worst performing asset class in our sample,” according to the study.

“Our findings are consistent with evidence from a range of earlier studies and add further weight to the evidence against the theoretical arguments for equities as a real asset class providing inflation protection when inflation is rising.”

Over the 18 months after the shock, real returns were negative, though less negative than bonds, which get hammered by inflation. Equities improve a bit over the next couple of years, but even when looked at in the long run of more than five years an inflation shock makes for losses in real terms.

IN THE LONG RUN WE’RE ALL …
As for the other asset prices, inflation proves very difficult to hedge against even over the longer term. Take commodities, the star performer in the first 18 months after inflation bites; spot prices decline in the medium term and when you get above five years after the inflationary event you are looking at actual losses in spot prices. This might be because inflation hits demand, but also might be because high prices spur greater investment in efficiency, which over the long term also moderates demand.

While bonds get killed in the first couple of years after an inflation shock, after about three years returns improve, presumably partly because investors demand higher yields to make up for nasty recent experiences.

Cash returns do a bit better, but even cash, which can go where it likes in search of better returns as inflation increases, fails to serve as a perfect hedge over the longer term.

So, how to hedge against inflation? Inflation-protected bonds such as TIPS would work, but to be a hedge you have to buy and hold to maturity, as outside forces can easily distort returns through the life of a given bond.

Given that inflation is a portfolio killer, why then are equity markets booming? Well, in emerging markets where inflation is kicking in first they are not. In developed markets, investors seem to be placing a touching amount of faith in central bankers. After all, if the Federal Reserve and ECB don’t pull the plug on stimulus in time, inflation can easily get out of control.

Or perhaps equity markets are betting the central banks will fail to stoke growth and be forced to blow a larger asset market bubble as a consequence.

Or maybe everybody thinks they will be the genius who gets out in time.

(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. email: jamessaft@jamessaft.com)