The ongoing demise of the Bretton Woods II (BWII) currency system and its implications for the balance of world growth has been a recurrent theme for this blog. And if recent commentary around China is any guide, the breakdown is accelerating toward another critical moment.
To recount, this blogger wrote last year:
BWII is the tacitly agreed system of a $US reserve currency kept strong by emerging markets that buy dollars to keep their own currencies weak. In effect, it’s a kind of unofficial Marshall Plan in which the US consumes and runs deficits nobody else can, whilst emerging economies fast-track economic growth by exporting into the US market. The giant surpluses resulting from the currency pegs are then re-loaned to the US. The dynamics are particularly strong in the Chinese/US relationship.
Clearly these dynamics ultimately result in huge external imbalances for all involved. The GFC was the reckoning of those imbalances. Both deficits and surpluses dramatically contracted after the banks that mediated the saving of one into the debt of the other collapsed.
The Chinese of course responded with a dramatic expansion of domestic credit to offset the decline in external demand. That expansion has since driven the global recovery through strong commodity demand. A virtuous cycle was completed when low US interest rates and QE pushed the $US down and stoked further commodity inflation (relative to a declining dollar). The yuan fell too because of its peg to the dollar and Chinese exports remain strong.
Last year this blogger called this “China’s undead growth” because although it appears to be a return to the same BWII system that dominated world growth after the millennium, it isn’t. China is now the epi-centre of frenzied credit growth, not the US, despite (or because of) retention of the currency peg.
And suddenly the major shortcoming of this strategy is becoming clear: Inflation. Irish commentator, Charlie Fell, sums it up nicely:
The primary factor behind the rise in inflation during the current episode is a surge in the money supply. M1 growth accelerated from nine per cent year-on-year in December 2008 to 32 per cent a year later and peaked at 39 per cent last January. In spite of a series of measures including a 3 ½ percentage point increase in the required reserve ratio to a record 19 per cent alongside a half percentage point hike in benchmark interest rates, M1 growth is still running close to 20 per cent year-on-year – several percentage points above the rate consistent with high single-digit growth in real output.
Year-on-year growth in M1 exhibits a strong correlation with CPI, with a six to twelve-month lag, and the relationship suggests that monthly CPI could peak at seven per cent year-on-year during the first half of 2011. This observation is corroborated by the PBOC’s most recent survey of depositors, which indicates their expectations are consistent with consumer price inflation of more than six per cent next year.
…China’s quasi-fixed exchange rate vis-à-vis the US dollar compromises monetary policy independence and the central bank’s ability to slow the economy through conventional means. Interest rates cannot be raised significantly because the resulting capital inflows would place further upward pressure on the currency, which would then require acceleration in the rate of reserve accumulation and substantial sterilisation operations to prevent a sharp increase in the money supply and growing inflationary pressures thereof.
China’s exchange rate policy means that interest rates are determined more by the Federal Reserve in Washington than the PBOC in Beijing. This means that the banking sector’s reserve requirement ratio has become the primary policy tool used by the central bank to mop up speculative capital inflows and reduce excess liquidity. Indeed, the negligible increase in interest rates so far is nowhere near sufficient to ease price pressures, as both deposit and lending rates are below current expectations of future inflation and thus negative in real terms.
Speculative capital inflows are already thwarting the PBOC’s efforts to control the money supply and quantitative easing in the U.S. has added fuel to the fire. The rate of foreign exchange reserve accumulation remained relatively constant at roughly $65 to $66 billion per month during last year’s third and fourth quarters, but it is of some concern that speculative inflows jumped from less than $16 billion per month in the autumn to more than $60 billion per month during the final three months of the year.
In short, Chinese authorities are already at the point of no return. And if they move further to cool the economy with interest rate rises they risk a classic upwards spiral into a bust as hot money chases rates higher.
Also writing late last week, Ambrose Evans-Pritchard agrees, but further argued that to not use interest rates is fatal too:
The French bank [SocGen] has told clients to hedge against the danger of a blow-off spike in Chinese growth over coming months that will push commodity prices much higher, followed by a sudden reversal as China slams on the brakes.
In a report entitled The Dragon which played with fire, the bank’s global team said China had carried out its own version of “quantitative easing”, cranking up credit by 20 trillion (£1.9 trillion) or 50pc of GDP over the past two years. It has waited too long to drain excess stimulus.
“Policy makers are already behind the curve. According to our Taylor Rule analysis, the tightening needed is about 250 basis points,” said the report, by Alain Bokobza, Glenn Maguire and Wei Yao.
The Politiburo may be tempted to put off hard decisions until the leadership transition in 2012 is safe. “The skew of risks is very much for an extended period of overheating, and therefore uncontained inflation,” it said.
Under the bank’s “risk scenario” – a 30pc probability – inflation will hit 10pc by the summer. “This would cause tremendous pain and fuel widespread social discontent,” and risks a “pernicious wage-price spiral”.
The bank said overheating may reach “peak frenzy” in mid-2011. Markets will then start to anticipate a hard-landing, which would see non-perfoming loans rise to 20pc (as in early 1990s) and a fall in bank shares of 50pc to 75pc over the following 12 months.
“We think growth could slow to 5pc by early 2012, which would be a drama for China. It would be the first hard-landing since 1994 and would destabilise the global economy. It is not our central scenario, but if it happens: commodities won’t like it; Asian equities won’t like it; and emerging markets won’t like it,” said Mr Bokobza, head of global asset allocation.
Needless to say, this blogger puts Australia at the top of the fallout list. As it wrote last October in reference to Chinese efforts to use credit to fight off the end of BWII:
In this scenario Australia becomes Ken Courtis’ light bulb plugged into the Chinese nuclear reactor. Chinese fixed investment and use of steel surges as the real estate bubble enters a blowoff phase.
As the $US falls, global equity markets at last have a seemingly sustainable narrative for US economic growth around export demand and the Dow powers ahead.
Commodities enter a combined demand and monetary boom that makes 2008 look like a dress rehearsal.
This may run for a couple of years and will look like an Australian Golden Age. But it ends in disaster as bad loans hobble Chinese banks when its bubble bursts and growth there slows permanently as it must grow through a balance-sheet recession. Even as tremendous new supply in commodities hits global markets.
For all of those that conclude the Chinese can simply round up the resulting bad loans and make them disappear, writing over the weekend, Michael Pettis offered an assessment of why rising bad loans for Chinese banks will be different this time around:
In that case, these analysts say, why worry? If there were another sharp rise in non-performing loans – as many, including Beijing’s banking regulators, expect – China would easily grow out of it again using the same combination of factors, and the cost to the economy would once again be minimal.
But they would be wrong. In fact the cost of cleaning up the last banking crisis was very high, much higher than simply calculating the explicit cost of recapitalizing the banks by direct and indirect equity infusions, and so will the cost of the next one be. The combination of implicit debt forgiveness and the wide spread between the lending and deposit rate has been a very large transfer of wealth from household depositors to banks and borrowers.This transfer is, effectively, a large hidden tax on household income, and it is this transfer that cleaned up the last banking mess.
It is not at all surprising, then, that over the past decade growth in China’s gross domestic product, powered by very cheap lending rates, has substantially exceeded the growth in household income, which was held back by this large hidden tax. It is also not at all surprising that household consumption has declined over the decade as a share of gross national product from a very low 45 percent at the beginning of the decade to an astonishingly low 36 percent last year.
This is how China’s last banking crisis was resolved. It did not result in a collapse in the banking system, but it nonetheless came with a heavy cost.The banking crisis in China resulted in a collapse (and there is no other word for it) in household consumption as a share of the economy.
This is why the People’s Bank of China is so worried about another surge in non-performing loans. If the household sector is forced once again to clean up a banking mess, this will make China even more reliant for growth on the trade surplus and on investment, and that is something many in Beijing, including the PBoC, do not want to see.
Indeed, that would simply be to lean more heavily on an already dead BWII system, inviting heavens knows what from trade partners.
This blogger will conclude by noting that in theory it’s not that hard. The best way to cool inflation without retarding growth is to raise the value of the yuan.
The Chinese refusal to do so and accept the end of BWII may result from an export dependency or the strength of export vested interests, or some other reason.
Whichever it is, the failure to act on the currency is swiftly developing into a major mistake.