Asia/Pacific: Free Money Reigns Supreme
Andy Xie (Hong Kong)
Asian interest rates have barely budged since the US Federal Reserve began to raise its policy rate. The enthusiasm of global investors towards Asian growth has kept capital inflow strong despite the rising Fed funds rate. The capital inflow has kept Asian interest rates low, which supports booming Asian growth. This, in turn, validates the global enthusiasm towards Asia, which keeps the funds coming. The fairytale continues.
Asia, in particular China, appears to be experiencing the biggest liquidity bubble in its history. The hot money inflow totaled US$656 billion in 2003–04, which has made money cheaper in Asia than in the US. The hot money turns into demand, primarily through property speculation.
I believe this global liquidity bubble, with China at its heart and property and hedge funds as its two lungs, will burst if: 1) the Fed raises interest rate quickly; 2) overcapacity overwhelms speculative demand, or 3) a financial accident occurs that decreases risk appetite.
Interest Rates Are Still Low
Asia’s interest rates have barely budged even though the Fed has raised interest rates by 150 basis points since mid-2004. The correlation between Asian and US interest rates is unusually low by historical standards. In China, the benchmark one-week repo rate for treasuries has declined significantly, though it backed up temporarily before the Chinese New Year due to seasonal money demand. Korea’s overnight policy rate had dropped by 50 bps. Other major economies in Asia saw half as much increase in interest rates as in the US.
Long-term interest rates in Asia have not budged much, either. China’s bond yield has dropped by 10–20 bps for 5–10-year bonds, the yield on the 5-year Taiwan government bond is down by 40 bps, Korea’s 5-year treasuries are up by 15 bps, and the yield on 5-year Thai treasuries has risen 50 bps since the Fed began its rate hikes.
Asia is largely financed by banks at the short end. Short-term interest rates are much more important than long-term rates that are often determined in illiquid markets. As the underlying inflation rate is probably around 4% in Asia, the real cost of money is still in negative territory.
Hot Money Is Still Hot
Exports and hot money are the two engines of Asian growth. The latter has become more important. Total foreign exchange reserves in Asia rose by US$335 billion last year, more than the region’s trade surplus of US$205 billion, and exceeding the US$321 billion surplus in 2003.
The difference between foreign exchange reserves and trade balance is the best indicator for hot money. The previous peak was US$68 billion in 1996, and it rose to over US$300 billion in both 2003 and 2004. The change in the flow of long-term capital could not possibly have contributed to the sudden surge in capital inflow. The hot money peaked in late 2003 and early 2004. The inflow was US$215.5 billion in the first quarter of 2004 alone. When China started to adopt a policy of macro tightening, the hot money began to leave in the second and third quarters. It came back and totaled US$118 billion in the fourth quarter when China signaled a more conciliatory tone toward macro tightening.
Nobody Wants to Burst the Bubble
The axis between the Fed and China has created the current bubble, in my view: The Fed keeps money supply loose, and China keeps inflation down. The excessive liquidity pumps up property prices in the US, which keeps US consumption strong, which, in turn, keeps China’s exports strong, in turn keeping China’s investment strong, which finally keeps commodity prices high (see The Motorcycle Diary, January 26, 2005).
China tried to tighten in the spring of 2004 and pulled back when the risk of a collapse appeared. With more hot money in the economy, China has even less incentive to do anything now. Given ample liquidity in the banking system and trillions of dollars of projects already approved, the risk in China is for the investment bubble to expand further, in my view.
In the US, the Fed appears to have little interest in bursting the bubble, with a low inflation rate the perfect excuse to keep interest rates low. US consumption could provide some bad news in the next two quarters, which would give the Fed the excuse to stop raising interest rates entirely.
The hole in this bubble is the expanding US trade deficit. Three Anglo-Saxon economies (the US, UK and Australia) have run up about US$700 billion in trade deficits. Most of the surpluses have actually occurred among oil exporters, not in Asia. However, because the market consensus is still for Asian currencies to appreciate, most of the money from the surplus economies has resulted in pushing up Asian currencies. Asian central banks have picked up the money and bought dollars. This unstable equilibrium appears to be holding up the global economy for now.
Alternative Bubble-Bursting Scenarios
I recommend that everyone read Charles Kindleberger’s Manias, Panics, and Crashes: A History of Financial Crises. It describes a world that resembles ours (lots of money, lots of speculation, lots of excitement about technologies or new growth areas, and not much inflation). The world of inflation ended with the break-up of the Soviet Union and China joining the global economy. We are in a world of deflation and asset bubbles. Central banks, however, are targeting inflation — the wrong target for today’s world, in my view. The misunderstanding by central banks on how the global economy works is the reason for the big bubble today.
While it is not midnight yet for today’s bubble, the coast is not clear, either. Everything is expensive, and this signals that it is too late to play the ‘catch a bubble’ game. I believe that the current bubble could collapse without interest rates rising too much. It could burn out on its own. A bubble grows exponentially by nature. When it stops expanding, it tends to collapse under its own weight. Until the era of the modern central bank, this was how bubbles burst.
Overcapacity is another way for bubbles to burst. Remember the Internet bubble? The oversupply of broadband capacity was the trigger. The fiction of infinite demand was pricked when prices for the bandwidth came down. This is particularly relevant for China, as it has a proven track record of over-investing.
A financial accident could also be a trigger. Considering how leveraged global financial markets are today, this risk should not be discounted. Commodities and emerging market debt are the most vulnerable, in my view.
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