China's Hooverian Twist and the New Asian Financial Crisis
From my blog, Malthusian Nectar
With the rapid decline of the Chinese real estate market, we are starting to see China’s central government step up and try to tackle its cooling economy. Unfortunately, many of these “solutions” have the potential to exacerbate the crisis further. And the whole crisis is starting to take on striking similarities to the United States’ crash in 1929 and the Asian Financial Crisis of 1997.
Let’s review some of the most recent moves from the PRC:
(1) A tariff on US automakers,
(2) A proposal to increase nominal tax rates in order to make tax code more progressive,
(3) Cutting bank reserve requirement ratios by 50 basis points,
(4) Effort to create more housing for low-income and middle-income individuals
(5) Declaring that the PRC is dedicated to “Yuan stability”,
In a nutshell, the solution has been tariffs, higher taxes, more supply, and hard money policies (with a minor exception). This is not that dissimilar to the playbook used by Herbert Hoover after the onset of the US Great Depression. There are, of course, significant differences as well; but I’m seeing a somewhat similar pattern of thinking towards the crisis.
The automotive tariff would impose duties of up to 21.5% on imported US automobiles. While this is certainly not as dramatic as the US’s Smoot-Hawley Tariff imposed after the 1929 crash; and it’s unlikely that this tariff would have a dramatic impact on either the US or Chinese economy; it nevertheless exposes Chinese policymakers flawed understanding the economics behind their crisis. Mercantilism is what got them into this mess and it’s not going to help get them out.
While China wants to reform its tax policies, some of China’s recent proposals are problematic, as economist Patrick Chovanec has documented. Due to the heavy burden China’s lower and middle income earners bear, China wants to reform its tax code to make it more progressive, by raising top nominal income tax rates and implementing a payroll tax on foreign workers. This might make some sense in the abstract, but starts to sound like more of the same once one understands the background.
The income tax rate hike does not close the gap in tax burden between the rich and poor in China, since China’s wealthy and well-connected elites are adept at avoiding the taxes altogether. Rather, this tax increase, as well as a new payroll tax, would largely hit foreigners working in China, while not providing any benefits in return. In essence, the taxes increase the cost of doing business in China, at a time when firms will likely find fewer reasons to be there in the first place. Once again, this is not as devastating as the Revenue Act of 1932 in the US which dramatically increased taxes during the Great Depression; but it exposes a similar flawed philosophy to try to shift the blame and burden to outsiders; just like the US did with the Mexican Repatriation Act in 1929.
The recent decision to cut the reserve ratios by 50 basis points is admittedly a move in the opposite direction. Clearly, it's designed to stimulate the economy and ease credit. Yet, there are reasons to question whether the policy will be effective. For starters, it seems unlikely that slightly lower interest rates (which might result from the easing) would create a large-scale effort by Chinese consumers to start purchasing property again, now that prices have already started plunging. Even if it does convince more people to borrow, it seems likely that these loans would also be unserviceable and have a higher probability of default. Therefore, it’s not clear that easing reserve requirements will actually be beneficial; and may actually prove detrimental, by pushing more people into overpriced assets, increasing the credit problems in China.
China’s attempt to speed up construction of housing for lower- and middle-income individuals is not necessarily similar to any Hoover-era policies; yet still seems strangely reminiscent of Hoover’s approach to the crisis. Due to the surge in housing prices, with much supply dedicated to luxury high-rises, the Chinese government has decided to promote more developments geared towards lower- and middle-income earners.
The problem: THERE’S ALREADY TOO MUCH SUPPLY! The issue was never lack of supply. Rather, the issue was too much investment demand (bolstered by easy money policies) and too little real demand from consumers. The latter was the result of prices that were too high; not lack of supply!
Given the massive overhang of housing, it’s very likely that prices are going to fall rapidly and some of that supply will slowly be absorbed over the next decade, thereby alleviating the pricing pressures on lower-income families. Building more supply into an already oversupplied market doesn’t exactly seem like a great solution to the crisis; it merely creates the potential for more bad loans being stuck absorbed by the banks or the PRC.
While all the prescriptions above seem wrong-headed, it’s the idea of Yuan stability that troubles me the most.
Yuan Stability and Hard Money
The real driver behind the fixed asset bubble has always been China’s currency policies. By artificially undervaluing the Yuan, China subsidized domestic capitalists in exporting industries. The policy also helped create more low-wage jobs for unskilled workers. Yet, both of these benefits come at a cost; most notably, it helped destroy the purchasing power of Chinese consumers, while also preventing the economy from developing more higher-skilled service jobs, that would pay middle class individuals higher wages. Perhaps even more importantly, it lead to massive misallocations of resources, promoting overproduction and under-consumption on a grand scale.
With the real estate bubble bursting, we are now seeing a reversal in the Yuan, with its intrinsic value falling versus the US Dollar. After a decade or more of moving in the opposite direction, many investors started to naively believe that the Yuan’s direction was a one-way street. Given China’s mercantilist disposition, one might expect for China to finally drop the Dollar peg, now that a weaker Yuan appears to be a foregone conclusion. After all, this would help stimulate their exports now that the Yuan is falling. Yet, reports indicate that China is dedicated to Yuan stability in 2012. This might be nothing more than hot air, but it could be troubling if the real estate markets continue to crash rapidly, and China sticks to its guns, effectively adopting a hard money policy, similar to the gold standard during the Great Depression.
As Dollars become more expensive, China will be forced to take on an increasingly punitive burden to maintain the peg, creating more pressure to devalue the currency. This is, in essence, precisely what happened in the Asian Financial Crisis of 1997, except that crisis began in Thailand, rather than China.
Maybe this is jumping the gun a bit, as it’s still not clear how China would react to a rapid depreciation in value of the Yuan, and there’s no reason to believe that China would hold its ground for long, given its accommodative posture historically; but all the same, a devaluation could be a dramatic market event that pushes the crisis further along. Let’s not forget that many surrounding nations are heavily dependent on exports to China.
The United States
While many expect a housing meltdown in China to have a devastating impact on the world economy, I view this as somewhat unlikely. Rather, the crisis will actually benefit many nations, including the United States. To understand why, it’s necessary to analyze the ramifications on trade and input prices.
Mercantilism is based on the idea that a nation must capture the largest piece of a fixed pie that it can grab. Liberal economic theory, on the other the other hand, argues that free trade creates greater wealth. This is because trade protections tend to reward inefficient producers and provide them with competitive advantages over more efficient companies. The net result is that the amount of goods and service produced is less, and the cost is higher. In other words, in the long-run, everyone wins with free trade.
China’s currency peg has been rewarding inefficient Chinese exporters for years. Meanwhile, the US has suffered as more efficient companies can be driven out of business because they have to compete against subsidized competitors. In effect, the currency peg has destroyed wealth , helping fuel a large current account deficit in the US, and making the American economy less well-off, due to weaker exporting industries.
On top of that, China’s fixed asset bubble created an artificially high demand for commodities. Copper prices, in particular, have shoot up as a result of the massive amount of Chinese construction activity. Talking to people in construction and home improvement in the US, I’ve heard numerous times how expensive copper prices have really hurt them. It’s no stretch to say that American consumption of commodities has weakened as a result of China’s Yuan peg and fixed asset bubble.
With the collapse of the Chinese asset bubble, we should start to see a reversal in commodity input prices, which will be highly beneficial to American producers and consumers. Moreover, the end of the Yuan’s artificially low valuation will benefit US exporting companies.
If you think this sounds crazy, consider what happened with Japan and the US in the 1990’s. The US economy was highly unstable and struggled throughout the ‘70s and into the early ‘80s, right when the Japanese “economic miracle” was happening. After the Plaza Accord of 1985, the US started to recover somewhat; and the US’s boom market only began after the collapse of the Japanese Asset Bubble in 1990. In essence, the exact same dynamic was playing out then. This isn’t to say the US won’t experience any affects as a result of China’s real estate market collapse, but the harm will be minor and short-lived.
If anything, China’s real estate collapse provides a great opportunity to invest in US companies. While I’m not quite predicting another 1990’s-like decade, US stocks are selling at historically cheap levels, and the US economy is much more resilient than many are giving it credit for. This is a good time to buy into the US markets for the long-term.
There will be major opportunities in East Asia eventually, but until we see this crisis play out for awhile, I would stay away from investing in China. Korea, Canada, and Australia will also struggle as a result of China’s crash.
I’d also be very skeptical of any major commodities or inputs, such as copper, silver, and steel for the near-term. As Chinese demand wanes, those metals, and the companies that produce them could suffer in a major way. Likewise, because gold’s rapid rise was directly related to the Yuan’s undervaluation, I expect it to turn out to be a poor long-term investment as well, as that trade reverses.
Disclosure: Author is short and/or owns long-dated put options on FXI, EWC, FCX, and SLV.