Asia Pacific: No More Next Bubble?
Andy Xie (Hong Kong)
Morgan Stanley
Aug 19, 2004
A new bubble has rescued the global economy from the bursting of an old one over the past two decades. The cumulative impact of the bubbles has lifted oil demand so much that it is fueling inflation, forcing central banks to reduce liquidity. I believe the global economy may be at the most important turning point in two decades, with central banks no longer able to pump liquidity to rekindle economic growth due to inflationary pressure. The global economy, especially the Anglo-Saxon areas that have boomed in the past 15 years, may experience a long period of slow growth, which would correct their external imbalances. I think the Anglo-Saxon central banks may not cut interest rates as aggressively as in the past during the next downturn—which could begin in earnest in mid-2005.
The liquidity bubbles that Anglo-Saxon central banks created in the past led to asset bubbles, which led to demand bubbles. This strong global demand has benefited the export-led Asian economies. China has benefited most since 1998. In my view, the Asian export-led growth model could become less effective during the Anglo-Saxon adjustment period, which may last for five years. China may have to introduce financial capitalism, which would attract more capital inflows to fund economic growth, to supplement an export engine that may become less potent in future. Key steps towards this process would include: 1) abolishing administrative controls over the supply and demand of stocks; 2) building a credit infrastructure for a corporate bond market; 3) privatizing banks, and 4) opening the capital account and floating the currency.
The Bubble Addiction
The global economy has been floating from one bubble to another. It began with Japan’s huge property bubble, which supported the global economy when the US was undergoing a structural transformation. A Southeast Asian capex/property bubble supported Asian growth at least in the early 1990s after Japan burst. When the Asian Financial Crisis hit in 1997-98, the US Federal Reserve tolerated a liquidity boom that spawned the Internet bubble. When the Internet bubble burst, the Fed tolerated another wave of liquidity, which has led to the global property bubble (see “Yo-Yo Economy, Quantum Markets,” January 30, 2001). Germany and Japan surpassed the US in manufacturing by the early 1980s. Market forces wanted the US to become smaller and Germany and Japan to get bigger. This process could happen through a widening gap in growth rates or through currency appreciation by Germany and Japan. The US preferred the latter, and the Plaza Accord sealed Japan’s fate. The subsequent yen appreciation made property investment more attractive relative to capital formation in sectors with faster depreciation. Japan’s rigid land market exaggerated the price move in the property market, triggering a massive price bubble. The currency appreciation held down the inflationary impact of the bubble, removing the main excuse for the central bank to tighten. The Bank of Japan made a major mistake by not looking at asset prices during a period of currency adjustment that distorted the inflationary picture, in my view.
When Japan burst, US interest rates came down sharply, which sparked capital inflows into Asia. The liquidity fueled a capex/property boom in East Asia. Asian businesses borrowed heavily from European and Japanese banks in dollars, because they believed that their currencies would appreciate. The abundant dollar liquidity sustained this borrowing binge that, while it lasted, fueled an investment boom that validated optimism towards the region. When international capital was withdrawn from East Asia, the Fed accommodated the liquidity need by cutting interest rates even though the US economy was quite sound. That fueled a liquidity bubble in the US (see “Who Wants Asia’s Surplus Savings and Goods?” June 4, 1998). The liquidity bubble was manifested as an Internet mania that increased investment demand. The Asian downturn kept US inflation low. The combination delivered a strong US economy that bailed out East Asia and carried the global economy.
When the Internet bubble burst, the Fed again cut interest rates aggressively. The resulting liquidity boom triggered a global property boom that has kept demand strong around the world. The excess capacity created during the previous bubble kept inflation low, which justified a 1% Fed funds rate for 12 months. This boom has sparked the strongest export expansion in East Asia. The boom has become so big that it has increased demand for oil enough to cause inflation. The boom also swallowed up a vast area of arable land in China, which is causing food price inflation. The resulting inflation has caused negative real interest rates around the world, further fueling property demand.
The Property Burst May Be Coming
The inflation that the massive boom has caused will likely put an end to the property bubble. Even though the high oil price is slowing the global economy, most central banks (perhaps with South Korea’s as the only exception) cannot ease and will probably tighten to maintain price stability, in my view. I think the global liquidity boom could turn into a bust. The main sources of inflation are food and energy. Both are related to China’s boom. Because this boom is occurring in the Yangtze River Delta, the most fertile agricultural basin in China, food production is coming under pressure. Much food production is not profitable in China. Market forces are causing peasants to switch to cash crops that earn them a better living. But this reduces grain production. When agricultural land is lost to industrialization or urbanization, it cannot be brought back during a downturn. Hence, food inflation is here to stay, in my view.
Energy inflation is another repercussion of China’s boom. China accounts for only 4% of the nominal value of the global economy; however, the increase in its demand for oil is more than that of the rest of the world combined. High property prices are giving Chinese businesses the buying power to pay for expensive oil. The property market is a bubble, in my view. Hence, when property prices turn down, Chinese businesses will no longer be able to afford expensive oil, which should cause the oil price to correct. When the oil price turns down, inflationary pressure will ease. But this can’t happen without a major slowdown in China, and China will slow down when the property bubble deflates. Hence, at a minimum, I believe the current growth rate is not sustainable; there are not enough resources available to support it.
Furthermore, the property market is losing momentum around the world. Suddenly, from Los Angles to Shanghai, property transactions are happening under asking prices, and transaction volumes have shrunk sharply. It seems that the property market may have reached a turning point. Fed Chairman Greenspan says that property markets are local and that a national bubble, let alone the global one, is not likely. But because the Fed has increased liquidity so much this time, it is affecting property prices in most places at the same time. Fed policy has created a global property market, in my view. When a bubble loses momentum, it has a tendency to burst. I believe global property may begin to deflate in the coming 12 months. If this indeed occurs, the global economy will likely suffer a recession, as the growth that the bubble has borrowed from the future over the past two years will have to be paid back.
No More Bubbles Ahead?
Why is the world moving from one bubble to another? How could bubbles form so easily in the past two decades? The answers to both questions are related. Asset bubbles happen when central banks provide too much liquidity. But too much liquidity typically causes inflation, which then forces central banks to decrease liquidity. Hence, there must be a force that keeps inflation down to permit excessive liquidity to last. High productivity growth, for example, is a force that can keep inflation down. Technological progress and globalization are the twin sources of productivity growth. Integrating China into the global trading system has been the most important source of productivity gain from globalization. The decline in the prices of tradable goods reflects the productivity gain from globalization. The rising trade to GDP ratio in the global economy shows the extent of the globalization-led productivity gain. However, China’s export to GDP ratio is likely to reach 33% this year versus 7.2% two decades ago. China is a large economy, and the limit of its export to GDP ratio cannot be much higher than 33%, in my view. When this ratio stops rising, the productivity gain from globalization will also slow.
IT has been the other source of productivity growth. Its rising penetration in the service and manufacturing sector has added to productivity growth. The extra gain ends when IT has penetrated the whole economy. The financial markets are de-rating the tech sector, and its valuation is converging towards that of other mature industries. This suggests to me that IT penetration in the global economy is maxing out. Therefore, productivity from technological progress may also slow down in future. I have argued above that productivity growth may slow, which would make the global economy more inflation-prone. Central banks would therefore not be able to create liquidity as freely as they have in the past, in my view, and it would be difficult for bubbles to take hold. Fixed exchange rates are often viewed as an alternative mechanism that leads to bubbles. But fixed exchange rates do not create liquidity; they just allow liquidity from elsewhere to flow in unfiltered. The fixed exchange rates in Asia caused bubbles because the US or Japan was flooding the region with liquidity.
How Can China Sustain High Growth in a Slow World?
China has experienced a massive property bubble in the past two years. The low US interest rate pushed money into China, which caused the property bubble. I believe this is probably just months away from bursting. China could experience slow economic growth for two years along with the rest of the world. I argue above that productivity growth will be lower in future and that food and energy bottlenecks will cause inflation, making bubbles less likely in the global economy. Hence, in my view, China will not be able to leverage into strong global growth and liquidity for fast growth as much as before. I believe, therefore, that China needs to modify its development model to achieve a high growth rate again.
Rapid economic development depends on external income and capital inflow. The latter should be distinguished from capital inflow to generate external income, as in the export sector. The extent of capital inflow into ownership of Chinese assets that service the domestic economy has been limited, partly due to regulatory controls. Only the consumer sector has extensive foreign capital because it has been relatively open. Stock and bond markets have played a very limited role in China’s development. South Korea has attracted foreign capital inflow into its stock market equivalent to 15% of GDP. China has attracted about one-fifth as much, relative to its GDP, via IPOs in the Hong Kong market. If China can reform its stock market effectively, it could attract sufficient foreign capital to fund rapid economic growth even during a period of slower export growth.
Reforming the capital account and the exchange rate regime would attract foreign capital into China’s government bond market. Foreign investors would be more willing to take currency risk if the capital account were open and there were a liquid currency market for hedging purposes. Foreign ownership of the service sector is quite low relative to the manufacturing sector. China’s service sector accounts for only 33% of GDP. The ratio could rise to drive economic growth if efficient investment is pumped into this sector. China can improve the environment to encourage foreign capital inflows into its service sector, in my view. In my opinion, China needs to balance export- and capital-inflow-led development. China’s export base has become so large that it will be difficult to sustain its 15% annual growth rate. Further, with bubbles deflating everywhere, the demand environment is also likely to be less robust, in my view. On the other hand, there is much potential to promote capital inflow-led development. By reforming the capital markets and FDI into the service sector, China could sustain high GDP growth even during protracted global weakness.
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