Two Runaway Bubbles and Global Reflation
Credit Bubble Bulletin, by Doug Noland
August 29, 2003
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There is a strong consensus that the mortgage boom is over and that home prices will now quietly plateau. While convenient, such an outcome would be quite unBubble-like. It is the nature of entrenched speculative Bubbles that they run increasingly out of control - that is until prices eventually reverse and hammer the speculators. Today, the American homeowner has never felt as wealthy or as infatuated with housing as the ultimate investment. It has become a full-fledged mania, with spectacular price gains only reinforcing inflationary psychology. Many key markets are very short of inventory, with virtual buyers’ panic dynamics now in play. Enjoying the fruits of rampant asset inflation and ultra-easy equity extraction, the consumer is borrowing and spending aggressively. Refinancings have slowed markedly. However, the household sector has accumulated enormous liquidity over the past year. Additionally, inflated values have again set the stage for significant equity extraction (increasingly through home equity loans as opposed to refis). There is little in today’s rate or Credit availability environment that would lead me to believe retrenchment is imminent.
As Mr. Greenspan stated today, “A mild calibration of monetary policy to address asset bubbles does not and cannot work.” Well, how about 1% Fed funds with California (and other) home prices rising at an almost 20% clip? Major inflationary psychology (“blow-off”) has taken hold in housing markets from coast-to-coast. As such, Bubble dynamics would lead us to believe that surprises (Credit growth, resulting inflation and spending) will continue to be largely on the upside. Financial fragility remains the prominent wildcard.
China Bubble Watch:
I am also increasingly of the view that “upside surprises” are likely in store for the second historic Bubble now running on full throttle in China. Similar to the mortgage finance Bubble, I don’t believe analysts or policymakers really appreciate what has been developing. Many, in fact, have been quite dismissive of the Chinese economy, a view increasingly difficult to justify. And, again paralleling U.S. mortgage finance, when excesses reach the manic stage things have a way of becoming quite unstable and prone to running completely out of control.
August 26 – Australian Financial Review: “China’s economy appears to have overcome the effects of the severe acute respiratory syndrome crisis. Retail sales, industrial production and foreign direct investment rose sharply in July 2003… China’s demand for industrial raw materials is particularly strong, and analysts expect the country’s imports of such products to continue to rise. There was strong growth in China’s consumption of key commodities such as alumina, copper, zinc, nickel and stainless steel in 2002, as more multinationals elected to use China as a major manufacturing base.”
August 29 – Dow Jones: “During the next 17 years, China plans to build 30 nuclear plants with capacity totaling 32 million-40 million kilowatts, state media reported Friday. Based on China’s gross domestic product target of $4 trillion by 2020, the National Development & Reform Commission forecast China will need power generation capacity of 800 million-850 million KW by that year, compared with the current 350 million kilowatts, reported the government-run newspaper People’s Daily.”
This past weekend The Peoples Bank of China announced that it would raise the bank deposit reserve ratio from 6% to 7%. Bloomberg’s William Pesek wrote a good article with the poor title (I know, “Those who live in glass houses…”), “China’s Central Bank Takes Away Punchbowl.” Another economic commentator averred, “China’s actions…indicate that they will not allow the bubble to build further. This is bad news for global growth.” And another: “This is a smart move by the Chinese authorities, who are going to take a soft economic landing now instead of a hard economic landing later.” Well now, let’s not get all carried away by an inconsequential reserve adjustment. And we definitely cannot disregard Bubble dynamics that, over years, have developed powerful inflationary and speculative momentum. It is worth recalling that Japanese authorities raised the discount rate from 2.50% in mid-1989 to 6% by late 1990. And even with the 1990 equities collapse, the Japanese economy posted 5.9% growth during the first quarter of 1991. It was not until the third quarter of 1993 that GDP posted a 0.1% decline. And here at home, despite a collapsing NASDAQ and Fed funds at 6.50%, the booming economy did not post negative growth until the Q1 2001’s 0.6% decline (with only mild contraction over three quarters).
This week’s move by Chinese authorities will surely have little impact whatsoever on what is increasingly an unwieldy boom. If anything, it is evidence that the Chinese government is nervous, though understandably unwilling to take the risky measures that would be necessary to cool a clearly overheated economy. Contemporary central bankers – operating with global fiat currencies and unmanageable Credit systems - are notoriously soft. “Soft landings,” for the most part, are an urban myth.
The bottom line is that Chinese are in the throes of one heck of a boom, a circumstance that becomes much more significant for a lot of things (global growth, commodity prices, interest rates, financial stability, etc.) as the U.S. Post-boom Boom takes hold. China’s financial institutions are said “to have made loans at the fastest pace since 1996 in July” (Austin American-Statesman). From the People’s Daily: “New bank loans grew by 1.9 trillion yuan ($230 billion) in the first six months, almost equaling the total for the whole of last year, leading banking experts to predict that the loan growth will surpass 30 percent this year.” Money supply is running up almost 21% y-o-y, compared to about 15% one year ago and 14% two years ago. “Overall national fixed income investment hit 1.93 trillion yuan ($233 billion) in the first half of this year, up an annualized 31.1 percent, the highest growth rate in ten years.” “During the first six months of this year, production and investment in steel and iron sectors grew by 21 percent and 130 percent respectively…” “In June, new construction of housing projects increased by 27.9 percent, but sales jumped by 36.4 percent…” Automobile sales are up 30% y-o-y. Think for a moment about the role that the island of Japan came to play in the global economy. Then ponder the size of China and the number of hard-working, enterprising Chinese.
The SARS scare reduced economic growth from the first quarter’s 9.9% rate to 6.7% during the second quarter. But the Chinese economy (and the entire region) is now quickly bouncing back, with inflationary pressures building (as one would expect during the advanced stage of a protracted Credit boom). There are major housing Bubbles in key markets, and consumption is surging. July imports were up 35.3% y-o-y, compared to 28.9% during July 2002 and 7.5% during July 2001. As I have written in the past, the nature of inflationary manifestations changes over the course of a Credit boom. Going forward, I would expect much less talk of China “exporting” global deflation.
This week, Intel announced that it would invest $375 million to build its second manufacturing facility in China, joining scores of companies (large and small) rushing to participate in the boom. Direct foreign investment was up 34% during the first seven months of the year. There are now more than 400,000 foreign-funding companies set up to do business in China. Increasingly, there is an historic “gold rush” dynamic to the China boom that will certainly not be squelched by tinkering with reserve requirements. And demonstrating the self-reinforcing nature inherent to Credit booms, there is an interesting and significant dynamic at play regarding speculative financial flows: The greater the production boom and the larger its trade surpluses, the greater the expectation that the Chinese currency will eventually be revalued higher. This is leading to enormous speculative flows that only exacerbate the boom.
Official reserves are expanding by $10 billion per month and have reached $350 billion. China’s “embarrassment of riches” leaves it with an enormous treasure trove of purchasing power. The Chinese appear increasingly willing to spend. It is worth noting that Japanese July exports were up 5% y-o-y. And while exports to the U.S. were down 6%, exports to other Asian nations were up 13% y-o-y. Leading the pack, sales to China were up 28%. Chinese imports are now stoking Asian exports, fueling impressive regional growth that has real potential to help pull even Japan out of its morass.
It’s been awhile since the world has concurrently experienced Two Runaway Bubbles. And to have these companion booms now simultaneously lurching forward - fueled by unprecedented global monetary accommodation, Credit expansion, and speculative excess - is something truly extraordinary. Since the Japanese bust in the early nineties, recurring booms and busts and resulting global deflationary pressures provided, ironically, a quite auspicious environment for the blossoming U.S. Credit Bubble. Things are different these days: there are Two major unwieldy Bubbles increasingly inflating other economies. Moreover, there is presently a dearth of collapsing Bubbles working to offset inflationary pressures for the global system as a whole. These Changing Times would appear to provide a near ideal environment for gold, commodities, and other “hard” assets. At the same time, it is difficult to envisage how the unfolding global Reflation could be anywhere near as accommodating to U.S. financial assets. It is a backdrop that looks certain to test the mettle of the leveraged and speculation-rife U.S. Credit system.
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