From Observer, page 41, issue no. 342, November 19th, 2007
Translated by Zuo Maohong
Original article: [Chinese]
Bubbles, surplus, loss of control, imbalance… these all have been popular keywords used to describe China’s economy over the past several years. And in observing China's transitions and high-speed economic growth, it's not surprising. But when imbalance in the economy is worsening everywhere-- bubbles in the stock market, uncontrolled housing prices, expanding foreign exchanges, a soaring trade surplus, and a real interest rate of -3%-- they merit serious concern. While appearing to be independently caused, in fact they all share one root: the yuan's slow appreciation. Many say that a slow appreciation is meant to keep China from following the economic recession that Japan experienced in the 1990s. But in my opinion, on the contrary, it’s actually contributing to this.
A crawling yuan has brought imbalances everywhere.
“Move gradually” has always been the basic strategy of China’s economic reform, which evidence shows has been successful. However, if the same strategy is applied to financial pricing policies, the result may be reversed. This is because compared to the commodity market and other factor markets, operations in the financial market, as well as the values of financial assets, are totally dependent on market expectations, and the deviation between prices and values of financial products can instantly affect market participants’ actions.
For example, pork prices on a certain day is basically decided by the supply and demand ratio at that time. There may be expectations of rising pork prices and therefore growing investment in hog raising, which may consequently ease future pork prices. But this can’t affect the market’s supply and demand and further the price of the day, because it needs time to expand production and wait for other alterations to be effective. Therefore, general economic policies have enough room for “gradual moves”, and the same is true of the commodity market reform and social reforms.
But the financial market works differently. Take the yuan as an example: thanks to its high fluidity as a financial asset, any change in its supply and demand due to market expectations immediately affects prices in the market. In this case, the yuan’s exchange rate against the US dollar is more directly influenced by expectations of appreciation or depreciation of the currency.
Everybody knows that the yuan should appreciate by 15 percent, yet the government only allows a 5 percent growth each year, which means it has to “move gradually” for three years. The outcome then is apparent: familiar imbalances and high economic risks.
First, a suppressed yuan appreciation means its value is far higher than its price, and the government’s plan of keeping it at a 5 percent growth rate each year indicates the least possibility of the yuan’s depreciation. Any investor will turn to yuan-valued assets when seeing nearly zero-risk returns. Hot money or speculative capital from out of China therefore flows in.
Second, yuan deposits are reluctant to go out. Despite the introduction of the QDII system and the permission to individual investment in QDII last year, few are really interested in investing their money in foreign countries, as their first 5 percent return is soon wiped away when exchanged into yuan. And in the case of investing in zero-risk assets valued in either US dollars, HK dollar, euros, or yen, the returns are even lower than 5 percent.
Third, while more hot money rushes to China and domestic capital refuses to go out, while the trade surplus expands due to a suppressed exchange rate, while foreign exchange reserves keep piling up beyond the current level of 1.4 trillion US dollars. What shall we do with this huge sum of money? Where should we invest? Who should take the responsibility? Under such pressure, it becomes inevitable for state owned banks and enterprises to buy projects and firms in foreign countries, hence the establishment of the China Foreign Exchange Investment Corporation. And this makes the government a significant investor in the global market, which will bring inevitable challenges and waste.
The fourth outcome is trade surplus hikes. The yuan’s exchange rate can be considered as the prices of labor, environment, and resources in China. At this time, a faster yuan rise translates into higher labor prices in the international market and elevated costs for both environment pollution and resource consumption. On the contrary, if the yuan only tiptoes forward, China’s manpower and natural resources are then consumed at excessively low prices, which guarantees a continued ballooning trade surplus.
All this money has to find its way. And so come the unbelievably high prices in some asset markets once huge money squeezes into it.
So where can this money exactly go?
The most popular way of investment for Chinese is obviously deposits in banks. However, depositors find they are actually losing money by handing over their money to savings accounts, because the previous consecutive interest rate rises don’t really work—with the benchmark at about 3.5% and inflation at 6.5%, real interest rate is still negative. And as long as the real interest rate stays negative, rate hikes won’t succeed in guiding investment directions as previously assumed.
The second most reliable investment is real estate, as it’s a visible and tangible asset, and also brings immediate profit when rented. When domestic and foreign capital is highly excessive and deposits inadvisable, massive money naturally surges to the real estate market, and brings up prices in one swoop. Despite the desperate efforts the government has made in the prior period to restrain housing prices, they are still flying, as there is just too much excessive liquidity due to such a slow yuan appreciation.
Bubbles in the stock market are the biggest social and economical risk in the coming years.
The direct and indirect support from stock and securities departments in the past years, the decreasing interest rate, the lowering return in the real-estate sector and foreign investment, all these factors make the stock market a good choice for surplus funds. As most surplus funds go to the stock market, bubbles will emerge. The average price-earnings ratio is now around 60. If the irregular, and non-core security income (which counts for 25% of the price earning ratio of listed companies) are excluded, and the core revenue is counted, the PE ratio will reach 80, close to the recorded 100 in the 1990 Japan Stock Market. The stock bubbles are becoming distinct. Up to now, more than 120 million accounts have been opened, and people young and old are all pouring to the stock market, making it phenomenon of national proportions.
Why are stock bubbles the biggest economical and social risk in China in the coming years? Some years ago, scholars predict that bad accounts in the bank may finally put an end to the rapid growth in China and lead to a financial crisis. However, the banking system still remains in good shape and the economy continues to grow, leaving one wondering if there is any difference between the stock bubbles and the bad bank accounts of before? We can find the answer from the following three aspects:
First, we can not see the bad debts in domestic banks from the standard view of market economy.
As the banks in China are mostly state owned, no matter how high the bad account rate is, as long as the state finance is good, there is no need to panic about banks going under, and thus no possibility for a financial crisis. In other words, in the state controlled system, there is no bank bad accounts problem in the market economy theory, there is only problem for the state finance. In fact, in 2002, the official figure for the bad accounts was 25%, counter that with Standard & Poor's figure of 50%. However, the figure decreased to 6.6% percent thanks to funds from the state treasury and foreign exchange. Isn’t it wonderful that banks are always safe under the shelter of a sound state treasury? Why not just let them remain as state owned banks, why bother introducing commercial reforms? When the government tries to pull them out of trouble, it’s sacrificing funds for social securities, retirement insurance, education, health care and farmers.
Second, what’s China is going through at the moment is similar to what the US did in years around 1929. Before the recession in the 1930s, Americans were not economically secured at all. On the one hand, the government hadn’t established any form of social securities, public securities, pensions or health care securities. Any need for such insurances could only be satisfied by citizen-managed insurance businesses. On the other, the industrial revolution and urbanization the country had been through during the 19th century spurred Americans to leave suburbs and their families, making them financially independent of them. All this had contributed to the severe blow to the American society when the disaster in the stock market broke out. The several crises the country faced later were milder as the social securities system was established during the worst of the recessions. China today is like the US in 1929 in that there are bubbles, but no well-developed social securities systems. There is a massive floating population, but no reliable financial backups. Individuals and families won’t be more immune from a nation-wide financial crisis than those US ones in 1929 if it really comes.
Another point is, the stock market has become the only market that everybody can participate in simultaneously throughout China. Many commodities, like clothing, food, and electric appliances, are sold nation-wide, but their prices are unlikely to fluctuate nation-wide at a same time. In comparison, if there is a slump in the stocks, all participants perceive their losses simultaneously. Especially when Chinese investors can buy stocks on margin but not sell them on margin, it’s only possible that everybody loses money together when bubbles pop.
Of course no one hopes to see such a result. So how do we avoid it?
Above all, the yuan should rise as quickly as possible so that people won’t be so sure of its 5 percent per year appreciation. In this way, hot money will lose its power, trade surpluses will ease, foreign exchange will fall, and liquidity will shrink. Secondly, interest rates should ascend faster so that savings accounts can at least attract some people, which, to some extent, will helps ease the pressure in the real estate and stock market. Besides, the government should take the golden chance of a flourishing stock market to introduce a shorting mechanism, which will certainly guide stock prices to a more reasonable level, and improve the quality of the stock market. Moreover, access to market listings should be completely open to private enterprises. By this, not only will stock supplies increase, but stocks will truly be a true channel for social innovation.
(The author is a professor on financial economics at Yale University, and a visiting professor of Cheung Kong Graduate School of Business）
