Good News: China’s a Bubble

November 19, 2010

Hugh Hendry, the hedge fund manager and inflation skeptic whose views I have always found informative and interesting, sat on a panel at a conference last February called the Russia Forum. I finally found footage of the full panel. On the whole, he was his usual opinionated self, but he did shed some light on the China situation. Although the remarks are months old, I think his views are entirely applicable today.

The panel, chaired by Marc Faber, consisted of himself, Nassim Taleb (author of Fooled by Randomness and The Black Swan), Michael Gomez of Pimco, David North of General Investment Management, and Michael Powers of Investec, were asked whether or not China is a bubble. Nassim Taleb, in his usual style, said that if people were looking for the “hot” growing country to invest in in 1900, they would have picked Argentina before the United States and so things are really only obvious in hindsight. Hugh Hendry, more willing to put his sense of pattern recognition where his mouth is, answered a definite yes.

His grounds were that a nation that is simultaneously a large foreign creditor and running a trade surplus comes to a bad end unless one or the other of those things changes. It creates a massive asset bubble that ultimately leads to a deflationary depression. China is in that situation now, he says. Japan was in that same situation in 1990, and, strange though it is to think of the United States as a creditor nation, it was in that same situation in 1929.

Of course, correlation does not imply causation and this could all be an interesting coincidence, but the proposed mechanism makes it a plausible hypothesis. Obviously a nation that is a large foreign creditor and that has a large trade surplus winds up with a huge amount of cash bouncing around its economy beyond what it requires domestically. This creates a pressure on the extra money that should push it back out into the world, as the people of the country spend it on foreign goods and services. Ultimately, this turns the trade surplus into a trade deficit fairly rapidly. If, however, this natural process is obstructed by economic forces or explicit government policy, that money has nowhere to go except into pumping up domestic asset prices.

Although it is further back in history than Hendry would go, Spain and Portugal had a similar problem. Adam Smith records that because of their possession of the very productive gold and silver mines of their American empires, massive amounts of money flowed in. However, mercantilist ideas of the time equated the wealth of a nation with the amount of gold and silver in it, and so the countries banned or imposed an export duty on the two metals. As a result, Smith writes that Spain and Portugal were “the two most beggarly countries in Europe.” Adam Smith likens this process to building a dam; if you dam a river without altering its course in any way, the water will eventually overflow the dam and keep flowing exactly as it did before; there will just be created a lake of liquidity deep enough to drown in.

In the United States, Hendry claims that the gold standard prevented that money from going abroad (and much of Europe at the time had little for the US to purchase), a situation that a modern floating exchange rate would prevent. China, of course, does not have a floating exchange rate. In fact, not only does China use a fixed rate, but it actually forces its exporters to surrender their foreign currency in exchange for yuan at the government’s official rate. That money ultimately winds up in the hands of China’s central bank, which adds it to the bottomless pot of foreign reserves. The alternative, as I stated, is that the exporters could use that money to purchase foreign goods and services that they might actually enjoy. Hendry provocatively describes this policy as turning Chinese citizens into worker ants, and it results in the Chinese working for less than they’re worth, and forced into overpriced real estate, all to feed the current account surplus. He seems to think of it as a financial imperial ambition where China is placing financial global influence over economic stability.

Evidence suggests, though, that this ambition of China is rapidly becoming more trouble than it’s worth. China has (very slowly) been trying to allow the yuan to appreciate, and last August also began to allow exporters to keep some of their  foreign currency holdings offshore, where they would not have to be converted. Be that as it may, asset bubbles are called bubbles, rather than balloons, for a reason. With balloons, the air can be let out in a gradual and controlled process, but bubbles only burst.

Given the fact that China’s is inevitably doomed if they continue their policy, I still don’t know how to respond to Obama’s call for China to liberalize its exchange rate policy. It may be part of a Sir Humphrey-type grand strategy, where Obama is calling for China to liberalize its exchange rate in the hopes that it will force them to dig in their heels and not do it. On the one hand, the principle of self-determination must mean that China has a fundamental right to destroy its economy however it pleases. Furthermore, it would be nice to see one of the United States’ rivals for global supremacy to suffer a setback, and it might result in some recovery of manufacturing in the United States. But on the other hand, recessions have messy unforeseen consequences, and I’m not sure that China would handle widespread civil unrest very well.

Either way, I recall that in the 80s people were worried that Japan had somehow managed to repeal the ordinary laws of economics, when all they had really done was set the stage for a lost decade. One would have thought our own experience with bubbles would have left us more alert for other peoples’.

Leave a Reply