The China Bubble and its Impact on U.S. Debt

* I want to extend yesterday’s conversation on China. One of the on-going debates pertains to how much patience China will have as a holder of US debt, while the US continues to run $1+ trillion deficits. While China has never threatened to sell US debt, this has been a persistent concern of market participants. I think I have come up with a viable scenario which will ultimately result in Chinese sales of their US Treasury holdings. I start off with a discussion of Chinese inflation and then onto further conclusions.


Yesterday I cited the reported information that China is running a money supply (M2) almost twice the size of its GDP. In contrast, M2 in the US is about 3/4th of the US GDP. Is this going to unleash a rash of inflation? Is this how China’s persistent trade surplus is going divert its energies? Yesterday there was a Bloomberg story discussing the property boom in China, and how maids were leaving the city to go speculate on real estate in the country. A quote from a real estate sales person at a development is quoted as saying:


     ”You should buy two,” the sharp sales girl suggested. “In three years, the price will have doubled. You could sell one and get one free.”


Does this sound like the US’s subprime bubble of 2002 to 2006? In Holland in 1635, the wealth from the new world flowed to the Bank of Amsterdam, and eventually fueled the Tulip Mania, in which the tulips planted in the soil were worth more than the land incubating them. The analogy to China in the present day is that China is absorbing the wealth of the world as the world’s leading exporter, just as Holland became the world’s banker, issuing gold and silver backed deposit notes in the 1600s. The point here is that inflation follows growth in money and wealth, and that China is a poster child for that role.


Another concern I have about China is to try and figure out how the government is funding the massive growth in money supply and the economy. Is China just printing money? After considerable effort, I was able to find the balance sheet for the People’s Central Bank of China (PBC). It turns out that their balance sheet adds up to $3.3 trillion US dollar equivalents, about 50% larger than the balance sheet of the US’s Federal Reserve Bank. The most notable component of the PBC’s balance sheet is $2.6 trillion of foreign exchange assets. The Chinese reality is that as companies earn foreign exchange, they deposit it with their local banks, and in turn, gives it to the PBC. The PBC puts the foreign exchange on their balance sheet, and issues Yuan to the company’s bank, which in turn, feeds this money into the local economy. In other words, there is a direct linkage between China’s export driven wealth and the local money supply. Whether the PBC is printing actual cash, or creating Yuan based deposits, which feeds into the growth of M2 is not relevant. What is relevant is the fact that China’s M2 is growing rapidly, and this growth is feeding domestic inflation in China. In contrast to the US, the M2/GDP ratio is about 3 times higher in China.


As with all bubbles, when the market gets too extended, and the supply of new buyers slows down to the point where the prices stop rising, is when these bubbles fall apart. In the case of the US subprime bubble, it was the Fed’s rate increases from 2004 to 2005, pushing up short term rates to over 5%, which started to make the economics of borrowing (sub-prime) money less attractive, and in turn, fostered the slow-down and eventual decline of US real estate prices. There have been news stories out of China about how the government is tightening the rules about increases in the amount of down-payments which buyers need to post for second and third homes.


Currently, Chinese house prices, in a 70 city survey, are up 11.7% over the last year, however the norm for the last 4 years averages around 5.6%, reflecting a break in the gains during the crisis of 2008/2009. And just yesterday, China announced plans for an additional $588 billion stimulus package. Their economy is growing at an annual rate of 11.9%, and a 16.9% rate if you add back in inflation. So why does the Chinese government feel as if they need to stimulate the economy to the tune of another $588 billion? Frankly, it is beyond my understanding of China, unless of course, the pace of economic growth is not sustainable, and the Chinese government does not want to see their economy slow down. Plain and simple, this is inflationary.


Everyone is assuming that the Chinese fixed exchange rate of 6.8 Yuan per dollar is suppressing the value of the Yuan. Everyone is so convinced that the Yuan will appreciate wildly if the government lets the Yuan float freely. The main reasons why foreigners want to own the Yuan is so they can invest in Yuan based assets, such as real estate. ETF’s currently allow foreigners the ability to purchase equity in Chinese companies, but it is harder for foreigners to invest in other Chinese real assets. If the Chinese government fosters policies to push up the price of real estate ahead of freely floating exchange rates, and the free flows of capital into and out of China, then foreigners will be less motivated to buy the Yuan, as the assets available to them to purchase, will now cost a lot more.


When any country fosters inflation, it results in the devaluation of its currency, relative to currencies which are not experiencing the same inflation. Perhaps this is China’s way to limit the value of the Yuan, which the US complains is being held artificially in check. And when the US insists that China tighten its monetary policy, in order to prevent the Yuan from strengthening relative to the dollar, the most significant asset which China has to sell to reduce its money supply is the $2.6 trillion of foreign currency reserves, which is 76% of its balance sheet. That will create strength in the Yuan, as the US is hoping for, but in turn will put pressure on US rates, and potentially a much greater debt crisis in the US.


So what happens when the Chinese real estate bubble bursts, and what does this mean to us in the US? For starters, this bubble could have much further to run, especially if China opens up its markets and economy to foreign investors, and allows its currency to float. I expect China to open up its markets to foreigners over the near term, and to let its currency float. The initial reaction to an opening up of markets will result in a surge of new investments in China, so I am not looking for this train to stop rolling anytime soon. However, there will come a time when this bubble will pop, and that is when the fun begins. China will work to stabilize its banks with exposure to loans on real estate, and China will likely need to find other things for the people working in real estate related to do. Of course, this means more stimulus. To fund the stimulus, as some point, China will look to convert its foreign currency reserves in exchange for the Yuan. In turn, this will hasten the day that the US has a funding crisis. More on this topic in the future.


* Greece and the PIIGS – the drama in the Greek bond market continues, as the Greek 2 year bond, now yields 15%, and rates on the rest of the PIIGS consortium are all significantly higher in the last 2 days: Ireland 2 year +1.15% to 3.51%, Spain +0.38% to 2.08%, Portugal +1.80% to 4.77% and Italy +0.30%, to 1.73%. While the situation in the other PIIGS is not as bad as in Greece, there is an influence from how high yields on Greek bonds have risen. Clearly, it is now understood that Greece has to present a viable plan to the IMF and EU, in order to get Germany to agree to go along with the rescue plan. The Greek government debt yield curve indicates that the market is mostly concerned about what happens with Greece after they have used the 45 billion Euros. Yields on 1 yr debt are 7%, while the yield on 2 year paper is 15%, 8% higher, which is the markets way of saying that they are concerned about Greece’s ability to repay its debt 2 years out.


And lastly, S&P just down-graded Greece to junk, which is resulting in a swift drop in US an European stocks. This will launch a sequence of consequences as Greek government bonds will no longer be eligible for collateral with the ECB, if Moodies follows suit. Stay tuned!


* Goldman on Capital Hill – are you watching what is going on? I fully appreciate that the Senators are trying to skewer the Goldman crew. Clearly they are not differentiating with the fact that the institutional markets are filled with sophisticated investors who should be able to analyze bonds, and make a judgement as to whether the price is commensurate with the risks. As many a participant will tell you, there are never just bad bonds, just bad prices.