Thursday, December 3, 2009

Chinese Economic Bubble

Remember the days when banks were willing to make loans with little checks on ability to repay?

It was not so long ago, that we experienced a period of irrational exuberance. Based on a belief of the sustainability /inevitability of economic growth / property price rises, financial institutions were willing to take many risks lending to people with few credit checks. We ended up with a situation where 100% mortgages, mortgages many times incomes were lent out.

Also, the Central Banks failed to anticipate we were in an asset bubble and the economy was more fragile than statistics suggested. As a result, monetary policy was kept too loose. At a time, when monetary policy should have been tighter, the Federal Reserve kept interest rates very low, encouraging a boom in credit and confidence.

Now, surely, we wouldn't make the same mistake again. But, the problem is that China faces many similarities with the boom and bust years we recently had.

China has had an impressive record of economic growth. This record has encouraged a sense of exuberant confidence. Chinese policy makers find it hard to envisage anything other than a continuation of these record growth levels. Chinese policy has come to rely on a continuation of breakneck growth to prevent unemployment and a rise in political dissent.
Monetary policy is lax. To promote this break neck growth, Chinese monetary policy is relatively lax. This is particularly the case with exchange rate policy. To keep exports cheap, the exchange rate is been kept undervalued providing an artificial stimulus for exporters.
Government policy also includes subsidies have included direct credit allocation and preferential treatment for coastal enterprises. This risks creating growth which doesn't reflect market conditions.
A situation of high confidence, and low interest rates is encouraging a growth in bank lending, not necessarily to profitable or careful investments.
There is a boom in construction even though there is evidence of over capacity (aka Spain)
Even statistics are dodgy. Chinese GDP stats record output produced, rather than output sold. There is a difference as not all output is sold, leading to excess capacity. But, also, GDP statistics are treated with caution because local officials have an incentive to exaggerate and record higher figures.

Of course, the similarities are not complete. There are many differences between the Chinese and US / UK experiences. China has a high saving ratio, low government borrowing and a current account surplus. If they chose, they have room for damping inflationary pressure and trying to switch economy from export based to more consumer based. China has the potential to make rapid productivity growth because many of its former state owned industries were so inefficient.

But, if the Chinese economic miracle did come unstuck, it could have profound implications for China and rest of world.

Personally, I feel that China is in a position to become the dominant economic force. But, that doesn't mean it won't have a bumpy ride on the way to becoming the worlds largest economy.

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