Wednesday, December 16, 2009

Getting concerned about China, and what it means for the US

I've been getting more concerned about how badly China can hurt us.
It starts with the fact that 35-50% of China's GDP is construction, much of it financed with credit, with plenty of evidence that many projects don't earn their cost of capital, many are shoddy, and most are underdepreciated.
Thus, China seems to definitely be in a construction bubble. As soon as projects aren't able to pay down their interest payments, it necessarily comes crashing down, similar to the subprime crisis here, but bigger, because it's a bigger percentage of GDP.
Thus, their banks will need a bailout (in fact, many already do). Presumably, the government will do exactly what ours did - drop interest rates to 0 and print bucketloads of money.
There are a number of very big issues with this. They can't be described sequentially because they're interrelated, but I'll do my best to be clear.
Firstly, there's a major human rights issue in China. There is speculation that the populace tolerates the ruling party because it can deliver growth. When growth is not coming, however, it is possible the ruling party will be thrown into turmoil because of its lack of protection of the welfare and rights of its citizens. Paul, a friend of mine knowledgeable on the topic, has noted two big components: a strong ethnic nationalism, currently directed against Japan, that could either strengthen the party or destroy it, depending on how well the government is able to direct it, and a highly professional military with the ability to maintain order. These factors could strongly influence the Chinese government's response to economic crisis, which is why I list them first.
Asset bubbles in the US and elsewhere:
Firstly, the Chinese savings rate is mid double digits. The government very well could decide not to backstop private savings the way that the FDIC does in the US (because of different senses of property rights and national priorities of infrastructure investment over private consumption), or it could decide to backstop savings because of the potential unrest if it doesn't (savings does constitute a large proportion of household wealth), or it could do some sort of intermediate step where savings is only backstopped if kept in the propped-up bank.
With a full backstop and recognition of property rights, it is not absurd to think that 0 interest rates in China could cause savers to look for better rates of return. This would create an asset bubble elsewhere in the world on a scale not seen in a long time. That's a lot of people, and a large percentage of their net worth in savings. Seeing as we're still recovering from the last asset bubble, another one would force us to raise interest rates quickly and keep us in recession.
With no backstop or an intermediate backstop, there aren't any moveable current savings, but future savings will likely be put in foreign assets. This results in an asset bubble, as well - smaller, and slower, but still destructive at this point. The intermediate backstop would be easier to pull, because banks would lose less credibility in the eyes of Chinese savers. This still isn't a great option. Either way, we're possibly looking at asset price inflation moving forward.
Inflation in the US:
With the credit bubble popped, just to avoid a liquidity trap/deflation, the government will need to print Yuan at a fast enough rate to make overcorrecting towards inflation a concern; if the government needs to keep delivering growth in order to quell human rights-related uprisings, it will be forced to start printing tremendous amounts of Yuan and actually cause purposeful inflation. Either way (and especially in the latter case), their currency will weaken. Especially if the country is chasing growth, it may no longer find it quite as appealing to use Yuan to purchase raw materials. Most countries wouldn't have a choice (the US didn't, and their currency actually strengthened because of the "risk-free" nature of treasuries), but China will have ~20% of the US monetary base sitting in the bank. It can use dollars to buy raw materials internationally and use the printed Yuan domestically (perhaps in a price-controlled manner, so they can get more "bang for the buck" at the expense of their populace). If China decides to start using significant numbers of dollars internationally, it could cause US inflation. This would require the raising of US interest rates, but it gets worse - because Chinese dollar holdings would be insensitive to interest rates, we'd have to raise interest rates on an artificially small portion of the monetary base, meaning rates have to increase more to stem inflation. Having just gone through a credit crisis, stagnating the economy won't be very popular. The most likely outcome is stagflation, 70s style. I'm going to come back to this point in a second.
Unemployment in the US:
The other problem is that massive excess capacity in China and a Chinese Yuan that's weaker (or, if you hold the Yuan to be artificially weak now, as most do, a Yuan that doesn't strengthen) means a whole lot of very cheap Chinese goods coming our way. Either we become protectionist (I'm against protectionism on particular industries, but an "import certificate" system or equal % tariffs on all Chinese goods may actually have to happen), or we get flooded with cheap Chinese goods. If US goods are getting more expensive but Chinese goods stay cheap, substitution towards Chinese goods would reduce US output and keep unemployment high. This is why on the inflation point, it is possible the US would let inflation happen  - it'd be better for us to have inflation if the real cost of living isnt rising bc of cheap imports than it is to have stagnation with a high unemployment rate.
Now, I do believe we see more protectionism, but that just means that when the current imbalances have worked themselves out and the Chinese deleveraging is over, we slow our economy down and cause more unemployment. So unless we time the removal of protectionism correctly (fat chance, given the way Congress works), we're still going to see more US unemployment.
How do we solve this?
The only way I can see out of an asset bubble and some combination of stagnation and inflation is increased consumption and decreased investment by the Chinese. This would help to fill up some of their excess capacity and mitigate the severity of their credit crisis. It would mitigate an asset bubble (less savings means less overseas investment), and presumably strengthen the dollar (so that Chinese government spending of dollar reserves doesn't weaken the currency as much). We see less inflation, and we don't see a flood of Chinese imports, so we recover more strongly. China has less overcapacity, so it gets hit less.
One way to facilitate increased Chinese consumer spending would be adjusting the tax code to stop favoring investment and to implement access to credit, health insurance, welfare, social security, etc. One reason the Chinese save so much is that they are encouraged to by their government, and there are no credit or social safety nets available to consumers. Most can't get loans, so any future spending - education, a house, getting sick, retiring, losing your job - has to get paid for from savings. Reducing the need for paying from savings would allow more to go towards consumption.
Of course, we can't implement that directly - we can only pressure the Chinese. In terms of how we can protect ourselves, general import certificates (closing the trade deficit without advantaging or disadvantaging any country or industry) is another way we could partially shield ourselves. It's not perfect by any stretch - the asset bubble could still occur and inflation from spending of dollar reserves could still occur - but it mitigates the unemployment issue. It still hurts American consumers because we have to pay more for our preferred goods (protectionism is almost never a good idea, except when your biggest trading partner is artificially manipulating their currency, as the Chinese are, or with specific brand-heavy but quality-neutral goods, as I've outlined before), but it hurts less than any other policy we could take at this point. Implementing this would almost certainly require a reduction in government spending, because we wouldn't be able to export dollars through trade anymore, which reduces demand for government bonds. If we don't cut government spending, interest rates/inflation go up anyway, and we have the stagflation conundrum again.
A temporary "hot money" tax could theoretically be helpful but is very difficult to implement in a country as dynamic as ours, and produces highly undesirable side effects, so that may be a poor policy option.

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