``Neither China nor the US can morph into more balanced economies overnight, and China can't tolerate a sharp RMB appreciation to speed up the process. So the adjustment scenario will be disappointing, involving slower US demand and Chinese export growth. And higher US rates will be a vehicle to reinforce that outcome. In fact, the ‘impossible trinity' may be hitting Asia in reverse. An Asian rebound would normally induce capital inflows, rising asset values, a stronger currency and a tighter policy. But no one wants currency strength, and it is too soon to tighten. So, the authorities can and will intervene in FX markets and will probably tolerate too-loose liquidity and rising asset prices. As global investors seek higher returns outside US markets, the accompanying decline in risk-aversion probably won't be good, either for the dollar or for US Treasuries.”-Richard Berner, Morgan Stanley, Challenges to Rebalancing the US Economy
US dollar bulls and deflation advocates wildly gloated over China’s 7% collapse in its stock market but closed down 5% last Wednesday.
One even paraded the prediction made by a team of quants [as we earlier featured in China In A Bubble, ASEAN Next Leg Up?] as rationalization for such activities.
What was thought to be an important inflection point, eventually turned out to be a short term “tryst” as China’s stock market robustly recovered and nearly expunged the losses going into the last 2 sessions of the week.
And this was met with a deafening silence from the US dollar bulls.
Figure 2: Asianbondsonline: China’s yield curve remains steep
As we earlier said we won’t bet on the ridiculous notion that bubbles would pop so soon because, as we wrote from our earlier article, ``bubbles normally take time to reach a climax. For instance, the US real estate bubble ballooned from 2002-2006, while global stock markets inflated from 2003-2007. True, today’s China bubble could risk being pricked hastily or abruptly, but in my view, this may seem too early.”
``It’s because normal bubble cycles need sustained massive infusions (we seem to be seeing the first phase) and the vast concentrations or clustering of resource misallocations that could either become huge enough to be extremely sensitive to interest rate hikes or would require continued exponential amplification of credit to maintain present price levels or a pyramiding dynamics…until the structure in itself can’t be sustained (usually interest rates from market or policy induced does the trick).”
If we look at the China’s yield curve (see figure 2), the persistent steepness signifies as continued ultra loose monetary landscape thereby potentially posing as additional fuel for more stock market conflagration to the upside.
Although of course, since no trend goes in a straight line, the clashing combination of severely overbought conditions and price “stickiness” from the power of monetary policies could translate into sharp volatility.
But then again, the bubble cycles can stretch much further than anyone can expect them to. As mainstream’s most favorite icon, John Maynard Keynes used to say, “the markets can remain irrational far longer than you and I can remain solvent”.
Speculation Or Eroding Store Of Value?
China’s bubble isn’t confined to China.
Most emerging and Asian markets including the Philippine Phisix have now exhibited manifestations of bubble like circumstances.
Even the conditions of the US markets appear emit the same signals. Commodities are likewise manifesting bubble symptoms.
Yet all of these appear to be in response to the trajectory of the US dollar index, which as of Friday’s close appear to be at the verge of breaking both the critical support levels etched in December 2008 and June 2009, as shown last week.
The implication of a breakdown of the US dollar index is that it could further reaccelerate the “speculative” frenzy as “stickiness” from policy induced inflation appears to be accelerating.
The obverse perspective from that of speculation is the question of the state of paper money’s store of value.
Business Cycles and Speculative Errors
Curiously too, it would seem bizarre how policymakers have been drudging and debating over identifying and controlling bubbles, when bubbles are the direct and indirect consequences of their policies and seem to be popping all over like mushrooms in a field.
Haven’t you noticed, as global central banks simultaneously coordinated a zero rate bound approach with some apply quantitative “money printing” easing (QE) measures combined with massive fiscal stimulus programs, the apparent consequence has been rising stocks and commodities?
Of course, suggestions that today’s risks may pose as something like a ‘car accident’ operate from the perspective of randomness, where “animal spirits” which have gone berserk would suddenly stop for unexplained reasons.
For us, while random shocks may indeed occur, the significant part of such observation is the crucial misunderstanding of the speculative process of the policy induced business cycle.
As Jeremie T.A. Rostan fittingly explains,
``Speculative error can go on at no cost as long as that limit is not reached. In fact, there are two other limits. First, the rate of interest tends to rise to its real value, undermining the pseudoprofitability of the real assets underlying sensitive and risky assets. Thus, new credit has to be created constantly. Second, the injection of liquidity will have to be stopped at some point, or else hyperinflation will take place.”
Proof?
China has been warning its banks over the possibility of asset bubbles. And through fiat has directed ``banks to ensure unprecedented volumes of new loans are channelled into the real economy and not diverted into equity or real estate markets” reports the Financial Times.
When two banks reportedly responded to curb lending the result was Wednesday’s stock market crash.
This from Robert Flint of the Wall Street Journal (all bold highlights mine), ``On Tuesday, two of China's major lenders were quoted as saying they would sharply slow credit growth in the second half. This prompted fears of a sudden tightening of credit that could choke off the loans which have so far eased the effects of the world recession. Shanghai equity prices plunged as much as 7.7% at one point Wednesday and closed 5.0% down on the day.
``Later on Wednesday, the PBOC said it will emphasize market-based systems, rather than administrative controls, in guiding the appropriate growth of credit. PBOC Vice Governor Su Ning's comments appeared to signal the PBOC wasn't about to set loan curbs in the second half of this year to cool explosive lending growth, as it had done in 2008.
``Nevertheless, Mr. Su's comments were the most forceful yet from China's central bank in trying to talk down the lending spree put into motion by Beijing's massive stimulus program.”
So the Chinese government tried unsuccessfully to jawbone down the credit bacchanalia but the violent response from its credit addicted stock market, sent officials on an apparent U-turn.
Inflation Cycle and Price Controls
Has this been a surprise to us? The answer is NO.
We have been repeatedly saying all along that governments will persistently attempt to put a kibosh on the gamut of exploding surges of asset prices but the fear of recidivist recession or deflation will force them back into the same accommodative and expansionary stance.
That’s the legacy of government policy trends derived from the influences of central banking dogma.
And China’s official response has fallen precisely into the ambit of our expectations.
Moreover, policymakers are in a policy dilemma.
The appearance of short term gains from levitated asset prices has a reflexive feedback loop- it has successfully created the impression of an economic recovery, which subsequently has loosened up risk aversion thereby reducing demand for money but increasing the demand for holding assets.
Nevertheless these account for as footprints of inflation.
Policymakers are then on the hook to at least maintain present levels. Paradoxically, this requires even more credit creation.
As Ludwig von Mises wrote in Inflation and Price Controls (bold highlights mine),
``The problems the world must face today are those of runaway inflation. Such an inflation is always the outcome of a deliberate government policy. The government is on the one hand not prepared to restrict its expenditure. On the other hand it does not want to balance its budget by taxes levied or by loans from the public. It chooses inflation because it considers it as the minor evil. It goes on expanding credit and increasing the quantity of money in circulation because it does not see what the inevitable consequences of such a policy must be.”
And governments will attempt to conceal the adverse impact from their inflationary policies by diverting the public’s attention into scapegoating private enterprises and markets.
This extrapolates to the next measure-PRICE CONTROLS.
Again from Mr. von Mises from the same article, ``The real danger does not consist in what has happened already, but in the spurious doctrines from which these events have sprung. The superstition that it is possible for the government to eschew the inexorable consequences of inflation by price control is the main peril. For this doctrine diverts the public’s attention from the core of the problem. While the authorities are engaged in a useless fight against the attendant phenomena, only few people are attacking the source of the evil, the Treasury’s methods of providing for the enormous expenditures. While the bureaus make headlines with their activities, the statistical figures concerning the increase in the nation’s currency are relegated to an inconspicuous place in the newspapers’ financial pages.”
Evidence?
Each time oil prices went down during the last month they coincided with a barrage of fire from regulators whom have threatened to curb speculative trading (July 7, NYT) or impose additional regulations supposedly inspired from purported study that is due out soon, that pins the blame on speculators as “driving the wild swings in oil prices” (WSJ July 28)
Figure 3: Stockcharts.com: Oil Prices and Threats of Price controls
The blue arrows denotes of the dates where the threats of added scrutiny or imposition of price controls on oil trading had been broached.
Apparently, the efficacy of such government sponsored communication signals to rein the oil markets appears to be diminishing.
In addition, because of the fear of further reemergence of falling prices from short selling, new rules are being imposed (WSJ, July 28)
Since regulators such as David Altig, senior vice president and research director at the Atlanta Fed, concede that ``Markets are, everywhere and always, one step (or more) ahead of regulators”, this implies that stifling regulation will only cause market inefficiencies by the circumvention of the regulation by arbitraging on different but related markets or financial innovation.
To quote the WSJ, ``The [CME group] exchange's chief executive, Craig Donohue, said: "We are deeply concerned that inappropriate regulation of these markets will cause market participants to move to dark pools and other unregulated markets, causing irrevocable harm to the entire U.S. economy." Dark pools are private markets where large orders are transacted.” (bold highlight mine)
In effect, adamant denials of the culpability of government inflationary policies will only result to the aggravation of the problem and only heighten volatility risks.
Too bad regulators can’t seem to accept God’s natural laws of supply and demand as having more power than their bloated egos.
Asia: More Room For Bubble Blowing
Going back to Asia this very interesting chart from Nomura Securities (see figure 4). (HT: Fullermoney) appear to support the legs for a continued bubble blowing.
Figure 4: Nomura Securities: Asia & West At Opposite Poles
In Nomura’s Mixo Das and Paul Shulte chart, they project that Asia will likely outperform for the following reasons:
One. Low banking system leverage.
As per Nomura’s Mr. Das and Shulte, ``Asia has NO forced sale of assets, so it gets free reflation. Under-performance by Asia mutual/hedge funds, cash piles everywhere.”
Two. Deleveraging in bubble bust economies are likely to cause divergent flows in asset pricing trends with the East outperforming (aha! Decoupling is a myth!).
Three, Corporate tax increases in response to government programs to shore up national economies are likely to translate to higher relative shift in income that would benefit Asia and
Lastly, central bank balance sheets seem likely to favor Asia, as asset components are mainly on “safer” US treasuries compared to “toxic” or high risk assets for US or UK.
In short, yes, the bubble dynamics in Asia seem to have ample room to run based on sustained expansionary monetary policies coupled with conducive economic stories that should underpin the relative advantage of Asia vis-à-vis the West.
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