China: Global Landing Scenarios
Andy Xie (Hong Kong)
Morgan Stanley
Jun 10, 2004
Summary and Investment Conclusion
Facing rising inflation, the Fed has to raise interest rates, in my view. However, the inflationary pressure is an echo from a vast bubble that the Fed has created by keeping real interest rates negative; fighting inflation could pop the bubble.
The negative real interest rate has spawned property price bubbles in major Anglo-Saxon cities and a quantity property bubble in major cities in China. The global landing scenarios that remain are that one pops or both pop.
I would assign one-third odds to each of the three scenarios. If the Fed could raise interest rates very slowly, say, 25 bps per quarter, both bubbles may persist and may even expand for a while longer. If the Fed raises interest rates by 50 bps per quarter, as the market is currently expecting, the Anglo-Saxon property bubble may survive but China’s probably wouldn’t. If the Fed has to raise interest rates by 100 bps per quarter, which is the pattern that history would suggest, both bubbles are likely to pop.
Property prices in major cities will provide the key signals to the stability of this bubble. If the Fed manages to preserve both property bubbles during the reversal of its interest rate policy, the global economy could have a soft landing. However, the Sydney property bubble is already bursting. Could the others really survive?
Asset Bubbles Are the Real Story
The world is worrying about inflation. It should, but for a different reason. Surging demand for oil, minerals, metals, and grain since 2002 has sparked inflationary pressure. The force behind the demand surge is the bubbles spawned by negative real interest rates.
Massive capital flow into China caused a quantity bubble in its fixed investment sector (mainly in property and its supply industries). This has resulted in a surge in demand for related commodities and equipment, sparking a capex boom in the economies (especially emerging economies) that export such products to China.
The negative real interest rate also caused a property price bubble in major Anglo-Saxon cities. The wealth effect has supported a consumption boom in these cities, which is the foundation for the consumer-led growth in these economies. This consumption boom has also triggered rapid increase in demand for oil.
The high commodity prices are now seeping into other components of the consumer price index in the Anglo-Saxon economies, forcing their central banks to raise interest rates.
Why Should Central Banks Raise Interest Rates?
There are arguments as to why central banks should or should not react to cost-push inflation. The argument against raising interest rates is that it may trigger inflation expectations that may spark a vicious cycle of labor demanding higher wages and businesses raising prices to fund wage hikes. The argument in defense of raising interest rates is that globalization has decreased the slope of the labor supply curve in every economy and inflation expectations could take hold in an era of global labor competition.
I believe that the cost-push inflation matters greatly because it reflects misallocation of resources caused by the twin bubbles (see “The Twin Bubbles,” April 5, 2004). Addressing the current inflation is equivalent to deflating the bubbles.
Since the central banks, mainly the Fed, created the bubbles to create an upturn in the global economy, why should they want to deflate the bubbles? One could argue that the Fed should try to ignore the current inflation to the maximum extent possible and sustain the bubbles. Of course, the Fed would prefer to remove the negative real interest rate if the global economy could sustain the growth that the bubbles have sparked. Deflating bubbles would certainly destroy the growth momentum. Thus, the Fed’s dream scenario is that the interest rate goes up but the bubbles remain. The only possible way to get there is to increase interest rates as slowly as possible.
However, the bond market may not like it. The Fed has argued that it does not need to care about asset prices as long as it keeps inflation under control and, hence, the value of bonds has an anchor. If the Fed fudges its response to inflation, the confidence in the bond market could collapse, which would bring down the property market with it. This is why the Fed has to raise interest rates according to the wishes of the bond market even though it could pop the bubbles.
Does the Speed of Interest Rate Hikes Matter?
The argument in favor of raising interest rates slowly is that rapid rate hikes could cause big losses at the hedge funds that have carry-trades. The impact could mushroom into a financial crisis that engulfs a global financial system that is stitched together with complicated derivatives. This is certainly a valid argument considering how fast the hedge fund industry has grown in this cycle.
The speed of rate hikes also matters to the property developers in China that are caught with a huge inventory of works-in-progress. Because China has a pegged exchange rate regime, it must follow the Fed in its interest rate policy. The country is sitting on a massive amount of speculative capital that occurred with the expectation of renminbi appreciation, and the money has been lent out by China’s banking system. Otherwise, this stock of capital would leave, causing a liquidity crunch.
High rises dominate China’s property market; from land acquisition to completion, the cycle takes about three years. As the loans that fund property development are all short-term and property developers have little real equity capital, rising interest rates could trigger liquidity crises among property developers. Hence, if interest rates rise slowly, there would be less of these liquidity crises as more developers can complete and sell their developments before they run out of money.
Thus, if the twin bubbles are to remain, the Fed has to increase interest rates exceptionally slowly. My guess is that the Fed could raise interest rates by 25 bps per quarter in order to preserve both bubbles. The market has priced in a Fed that is twice as aggressive. It would take major disappointments in the US labor market for the market to accept such a scenario. This is why I believe that equity markets could remain strong only if the US labor market disappoints.
If the Fed raises interest rates by 50 bps per quarter as priced in the market now, I seriously doubt that China’s property bubble could remain intact. The market value of the property under construction plus completed buildings in inventory could reach US$600 billion by the end of 2004 (35% of 2004 GDP in my estimation). If the interest rate moves up by 2% in one year, the funding cost may rise by more than US$10 billion. Considering the limited real equity in this sector, many developers could go bankrupt.
Higher interest rates would also affect property demand in China significantly. The China Banking Regulatory Commission requires that mortgage payments should not exceed 50% of household income. As China’s mortgage products have floating short-term interest rates, rising interest rates could have a major impact on affordability. The current mortgage interest rate is about 5%. For a 20-year mortgage, the first year payment is 10% of the mortgage face value. If interest rates rise by 2%, the payment burden would rise by 20%.
What to Watch?
I assign one-third probability to each of the three landing scenarios for the global economy. The leading indicator would be the market expectation of how fast and by how much the Fed would raise interest rates. If new data points prompt the market to expect a more aggressive Fed, the bursting of the twin bubbles would become more likely. In such a scenario, an aggressive Fed would be quickly followed by a Fed easing again. However, unless another bubble materializes quickly, the global economy would be quite sluggish in this scenario.
If the Anglo-Saxon bubble stays but China’s pops, the global economy should fare quite a bit better. As China invests less, there would be more money to fuel the Anglo-Saxon bubble. Hence, property prices in London and New York could rise further in this scenario. The world would be similar to 1998 when the Anglo-Saxon economies did well but Asian economies did poorly.
If both bubbles remain, the global economy would be quite strong as it is now. The interest rate hikes would not dampen the growth momentum in the global economy. Financial markets are pricing in this scenario. However, I reiterate that it only warrants a one-third probability, in my view.
What Is the End-Game?
The world has been moving from one bubble to another since the 1985 Plaza Accord. Is it possible for the global economy to extricate itself from this vicious cycle? Of course, economics would tell us that there is an efficient equilibrium somewhere. The problem is that the Fed has been trying to solve structural problems with demand stimulus. Technology and globalization require capital and labor to be redeployed significantly. The process requires time and flexible factor markets. Many economies in the world do not have flexible factor markets. Instead of reforming factor markets, policymakers are tempted to use short-term solutions, i.e., demand stimulus, to cover up the structural problems.
The world would change only if the Fed refuses to ease during a downturn. It would then force policymakers to face structural problems and undertake difficult reforms. Some argue that that would be the end of globalization, because politicians could not push through the necessary reforms. Then, we are just postponing the day of reckoning with bubbles. The day of reckoning would surely come when the world has run out of bubbles to create. Would the world be better off on such a path?
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