China's Baby Steps Bubble

Baby steps blow bigger bubbles. The Chinese leadership is caught by its own indecision. What it thought was caution is turning out to be complaisance. Fear of the consequences will be not far behind.

For too long the government chanted the mantra of rapid growth and the importance of low interest rates and a dollar-linked currency. Then, reluctantly, it was forced to start making some moves, little ones because it was not convinced of their necessity. Then, as the little moves appeared to have scant impact, it began to worry that bigger ones would have too big a result ‑ that an over-bullish stock market would come crashing down, that a sharp rise in the yuan would cause exports to implode.

Interest rates have been kept at very low levels relative both to the strength of the economy and the gradual increase in inflation, now at over 3 percent, and money supply growth at 18 percent. Yuan appreciation has been slowed to a snail’s pace despite the dollar’s record low against the euro and its falls against other Asian currencies.

So the baby steps continue and the markets continue to ignore them. The latest 0.5 percent increase in bank reserve requirements was shrugged off with another 2 percent leap to yet another all-time record high on the Shanghai stock index. What is that, the market reasonably asks, when money is so cheap, local and foreign funds are flooding in and dollar buying by the central bank simply increases the local monetary base?

The higher the markets go the more reluctant the authorities are to take any steps that might seriously unnerve them. What price the job of the ministers or central bankers who set off a collapse of stock prices by 40 percent ‑ from the ridiculous to the merely over-priced?

So either they bury their heads in the sand and hope that baby steps will gradually have an impact and prices stabilize or gently decline. Or, more realistically, they do nothing in the expectation that sooner or later prices will collapse of their own accord, like Nasdaq in 2000, and there will be no call for a minister or central banker to take the blame for the “market cooling” measure which set off the collapse.

The Chinese authorities are in fact following just the same course of baby steps that the US Federal Reserve has followed ever since driving interest rates to record lows after creating and then swallowing the myth that the US was ever in danger of a deflationary spiral. Baby steps in the US created the housing loan bubble which has only just begun to deflate and – via the effects of the US deficit on global liquidity – the multiplicity of other bubbles from hedge funds and private equity to Philippine debt, which now pockmark global finance.

For China, a stock price collapse might do relatively little damage. Most of the run up has been fueled by cash rather than debt. Luckily for China’s stability, most debt is still owed by state-owned or linked entities, whether national, provincial or local. And most is owed to state banks which will get bailed out when necessary from the public purse.

A stock collapse is also unlikely to cause social unrest. There may now be tens of millions of punters who will get burned, but they are mostly those who have been doing well out of the system. It won’t mean much to most urban workers, let alone peasants. China’s citizens anyway are inveterate gamblers who are well aware that stocks are gambling chips and bad luck is more to be blamed on fate than government failures.

Nonetheless, no one in authority quite wants to face up to the need for a sharp fall in stock prices even though they know that the longer the rise goes on the steeper the fall will be.

Meanwhile, for the long-term health of the Chinese economy a bigger danger lies in its reluctance to face up to the currency issue. It seems to think it is getting away with baby revaluation just as the US believes it can get away with baby interest rate rises rather than facing up to its own massive under-saving and over-consumption.

Slowly but surely the mood in the US is changing. US Treasury Secretary Hank Paulson’s appeals for more action by China sound ever more desperate. And the mood in a Democrat-controlled Congress suggests that China will get the blame when US consumer demand finally collapses, not because of the baby-step interest rate rises but under the weight of the monstrous debt that it has assumed, and the reality of a level of inflation which makes a mockery of officially-engineered statistics.

Despite the cheerful prognostications of the investment banks, when the US catches pneumonia, all of Asia will have colds and China, hit by both over-reliance on the US market and by extra measures against it, will have a very severe case of the (non-avian) flu.