Asia/Pacific: The Motorcycle Diaries, Part II -- Liquidity Bubbles
[This seems to be the long winded version of the Crisis of Excess Liquidity that I wrote about the other day - Mish]
Andy Xie (Hong Kong)
Asset-based and debt-financed consumption in the US and government-sponsored and debt-financed investment in China are the two wheels for demand creation in the global economy. The rest of the world has come along for the ride driven by this motorcycle. The multiplier in this growth model is the reflation of emerging economies from higher commodity prices due to China’s investment bubble.
I believe this motorcycle model is prone to deflation rather than inflation, as demand creates its own supply. However, the speed limit for this model is not inflation; the inflation from higher commodity prices does not lead to a wage-price spiral due to global competition. Rather, financial stability as measured by excess capacity in China and the US’s trade deficit should be the primary consideration when looking at “speed limits.”
I believe that major central banks, the US Federal Reserve in particular, have failed to understand the inflation-deflation dynamics in today’s global economy and have provided the global economy with too much money. The extra demand for money has come from speculation in properties and carry trades.
Speculation has decreased the cost of capital and boosted the global economy. Hence, the high growth decreases risks in the global economy in the short term and validates the carry trades that depress risk premium, which fuels more carry trades and more global growth.
As a result, containing speculation has become the biggest challenge for monetary authorities around the world, in my view. The expansion of the current liquidity bubble is causing a significant amount of value destruction globally. If the bubble bursts, the destroyed value is set to haunt the global financial system.
I believe the correct policy for monetary authorities is to increase interest rates rapidly until property prices begin to fall, although this would cause a global recession. The wrong policy, in my view, is to justify low interest rates by citing low inflation, which could allow the bubble to expand until it crashes under its own weight.
Absorbing the Competitive Shock
The former Soviet bloc countries and China abandoned economic planning and rejoined the global economy in the 1990s. However, the capital accumulated when their economies were planned was not very useful in the global economy, and they had to start creating wealth from scratch. This kept their currencies cheap relative to their productivity and was the structural force behind a series of emerging market crises in the 1990s.
The emerging market crises due to this competitive shock are over. Most emerging economies in Latin America and Southeast Asia have de-industrialized and now depend on exports of primary products. The global economy is compartmentalized into the rich consumption bloc (e.g., Anglo-Saxon economies, Europe, and Japan), the cheap labor bloc (e.g., China, India, and Vietnam), and the resource bloc (e.g., Australia, Africa, Russia, and Latin America). Today’s global economy structure is rational; the competitive shock from the old socialist bloc joining the global economy has mostly been absorbed.
Demand Creation in the New World
The ex-socialist bloc is under-consuming relative to its productivity in order to catch up with the West’s wealth levels. These economies, hence, are likely to save and invest. As a corollary, their currencies are cheap relative to their productivity. This puts pressure on other emerging economies and, to a lesser extent, on OECD economies to de-industrialize.
The process of de-industrialization under competitive pressure is contractionary. It forces labor markets to restructure towards non-tradable or high-tech sectors. The more flexible the labor market, the quicker the pain ends. The US economy is by far the most flexible and has adjusted quickest. This is the reason why the US economy is so vibrant and why trade with the US is so important for this new group of participants in the global economy.
Europe and Japan, however, have not been able to adjust quickly. They are much less flexible than the US and, therefore, are having trouble creating demand against this contractionary force. That has put the burden for demand creation disproportionately on the US. Essentially, the global economy outside the US is deflationary, and this is an environment that allows US monetary policy to remain easy without inflation accelerating. The US restructuring is the force that accommodates the entry of this group into the global economy.
Sustainable easing of monetary conditions implies a revaluation of financial assets. A portion of the valuation increase in US properties, bonds, and stocks can be attributed to this factor, i.e., deviation from the historical valuation is not necessarily a bubble and could be explained by changes in the global environment.
The appreciation of US financial assets has contributed substantially to US consumption but has also caused trade deficits, as part of the consumption is based on asset appreciation rather than income. Strong US consumption has kept the global economy from sliding into deflation, mainly via strong US imports that lift demand for investment-hungry economies and via the US trade deficit that pumps liquidity into the global economy, i.e., exporting the easy US monetary conditions to the rest of the global economy.
The easy US monetary conditions and strong US import demand work into the global economy mainly via China as the multiplier. China’s state-owned banking system tends to quickly turn liquidity from exports and “hot” money into fixed investment. The surging fixed investment translates into strong import demand for equipment and raw materials. The former gives a lift to aging industrial economies like Germany and Japan. The latter increases the volume of global demand for, and the prices of, raw materials.
The higher prices of raw materials are the most important multiplier on US monetary conditions through China, as this redistributes income from OECD economies to developing economies that have been suffering from the deflationary impact of de-industrialization. This marginal effect is critical to growth among emerging economies, which, in turn, contributes substantially to global growth.
Asset-based consumption in the US and debt-financed investment in China have become the two wheels that carry the global economy (see The Motorcycle Diaries, January 26, 2005). The sustainability of this model depends on whether the asset-based US consumption is sustainable and whether the Chinese people continue to believe in the solvency of their banking system. We do not know what the speed limit is in this world, because inflation is not the signal for sustainability.
One corollary is that growth and currency are negatively correlated for economies that benefit from the US-China growth engine. For commodity economies, this correlation can be offset by their improving terms of trade. For Europe, Japan, or the ex-Asian Tiger economies, their growth is likely to slow following currency appreciation.
The Vanishing ‘Juice’
The relaxed monetary conditions in the US have stimulated the growth of, for lack of a better word, “hot” money as investors try to escape from low interest rates. This hot money sloshes around the world via hedge funds, proprietary traders at international financial institutions, and high net worth individuals serviced by private bankers in search of yield.
The hot money first sucks the ‘juice’ out of the financial markets, as the ‘juice’ is the reward for taking risk. For example, an emerging economy has a higher probability, even though it may still be small, than a mature economy of going bust, and it should pay higher interest rates to issue bonds than a mature economy. The difference, or the spread, is the reward or ‘juice’ for taking this extra risk.
Yield curve is another form of juice. A bond with a long maturity carries more risk than one with a short maturity. The yield gap is the ‘juice’ for committing capital for longer.
Market volatility is another risk that usually demands reward. Investors are willing to pay for a product, such as the ‘straddle,’ that limits the fluctuation range of an investor’s portfolio.
Wall Street traders make a living mainly by buying risks (e.g., selling the straddle, borrowing at the short end and buying long bonds, or buying a high-risk bond and selling a lower-risk one), i.e., assuming that nothing actually happens during a period, with the risk premium becoming the traders’ profit.
Low interest rates are driving the broad investor community to take on more risks in exchange for higher yield. Two related phenomena are most important in that regard. First, private banking has grown rapidly by offering products that allow high net worth individuals to replicate what Wall Street traders do, i.e., take on more risk for yield pickup. Second is the large shift of institutional funds to hedge funds. Most hedge funds are quite similar to proprietary traders at Wall Street firms. In many cases, the hedge fund managers were the proprietary traders at Wall Street firms. The financial markets have experienced the commoditization of Wall Street trading strategies.
The enhanced risk appetite in the global financial system has created market trends that are seemingly inconsistent. For example, flattening of yields usually implies lower economic growth ahead, while a rising stock market usually means higher economic growth. However, the two have been happening together of late. I would suggest that both are driven by the increased risk appetite in the global financial system. In a world where everyone behaves like a Wall Street trader, risk premiums tend to vanish.
The Fine Line Between Re-rating and Bubble
The structural shift in the global economy does justify some re-rating of long-term assets, in my view. The bias towards savings and investment due to low wealth levels among new entrants in the global economy implies lower interest rates among OECD countries, as they are generally mature and don’t need to invest as much as before. China is the best example, in my view, as it accounted for about 4.5% of global GDP but about 10% of global gross investment last year. Also, China may have accounted for 20% of global net investment last year. This force should imply higher property values relative to income or higher price-earnings ratios for stocks among the OECD economies.
Is what’s going on in the global financial market just re-rating? I don’t believe so. Sustainability is the key test that separates optimism from euphoria in financial markets. In my view, the weakest links in the global economy today are: 1) that China’s investment boom is unsustainable, and 2) that the large US trade deficit that supports the global liquidity boom is also unsustainable.
China’s fixed investment is likely to exceed half of its GDP this year. The profit expectations that sustain the investment boom come from a vast property sector that is experiencing massive volume growth and rapid price appreciation at the same time. The properties under construction, when completed, are likely worth one-third of GDP at current prices. I believe that one-third or more of the property demand in China is due to speculation. Much of the remaining demand is borrowed from the future, as households that are spooked by rising prices stretch their budget to advance their purchase decisions. Consequently, I believe China’s property bubble is so large that it is unlikely to last for years, as many investors believe.
Nor is the US trade deficit at US$600 billion per annum sustainable, in my view. The rest of the world has not been using more money from the US deficit. So the US is not paying higher interest rates to fund the deficit. The situation could change, especially among oil exporters. The higher oil prices, compared to the 1990s average, have redistributed about US$300 billion per annum to oil exporters. All of the increase in the US trade deficit in the past five years can be explained by this factor. As other oil importers refuse to run deficits despite higher oil prices, all the burden for accommodating higher oil prices has been borne by the US directly or indirectly. There have already been signs of extravagant property projects in the Gulf region. When oil exporters believe that current oil prices are sustainable, they are likely to increase their spending, which I believe will push up US interest rates.
Guessing When the Bubble Pops
The unsustainable growth in the global economy is supported by a liquidity bubble, i.e., demand for liquidity based on an unrealistic assumption on future profitability. A liquidity bubble is most likely to happen in a low interest rate environment that spurs investors to take on more risks, which boosts economic growth by decreasing the cost of capital temporarily. The higher growth causes everybody to become more optimistic, which triggers bouts of “chasing trades that worked.” How long this can last is hard to tell. If the Fed raises interest rates quickly, it could frighten speculators. However, I believe the measured pace of raising interest rates that the Fed has signaled has emboldened speculators to go all out. To contain the bubble, the Fed would have to raise interest rates higher than it would have done without the ‘measured’ pace policy.
The significant growth of funds for investment (in particular hedge funds) seriously complicates monetary policy making, in my view, as unsustainable investment stories are often perpetuated by certain fund managers who seek short-term returns. This is one factor that I underestimated when I thought the bubble’s days were numbered at the beginning of 2004. There were enough investors in the market who had nothing to lose from counting on growth continuing that the wave of liquidity from such investors made growth last.
I believe the lifespan of the current bubble depends on the balance between the growth of “other people’s money” and the growth of the real economy. This is why I expect financial markets to come down first before the global economy falters. The global financial markets are in the second wave of a frenzy that began in September 2004 when China loosened up on its macro tightening. The previous wave began in May 2003 after the SARS epidemic and ended in April 2004 when China sounded serious about macro tightening.
Apart from monetary policy shocks (Mr. Greenspan wouldn’t pop the bubble), overcapacity could pop the bubble. For example, a major shock to oil supply could shake the market’s confidence in Asia’s growth prospects.
Overcapacity is already a serious problem in many industries, but investors appear to be ignoring this so far. I believe that the ultimate overcapacity story is happening in China’s property sector. The speculative demand funded by cheap money is holding up prices for now, but this appears to be a precarious equilibrium. When property prices begin to fall, which I believe is quite possible before the end of 2005, speculators will run from the market, in my view.
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