Two
weeks back, I wrote about changes in China's
foreign-currency regime, [1] which could set off a
worldwide panic. The implicit assumption in that
article, that Chinese policymakers would act
rationally, must, however, be tempered in the
context of the most recent actions.
Much
like the embedded irony of George W Bush waging
war for peace, in China's quest to become a
responsible citizen of the world, it appears that
it is becoming the exact opposite, at least
in financial matters. The
result will be both contagious and catastrophic as
all central banks battle their increasing
impotence by acting in concert, in turn setting
off a worldwide correction in stock markets, and
possibly a deep recession.
Even as China's
central bank has acknowledged in recent weeks an
increased desire to widen the trading band of its
currency, the yuan, it hasn't achieved much
appreciation in practice against the US dollar.
After all, multiplying the daily trading band by
the number of days it has been operational shows
that the yuan should have already doubled in
value, but has only instead eked out a
single-percentage-point increase. That, more than
any statement, shows that the People's Bank of
China (PBoC) has been actively buying up the US
dollar over the past few months, belying any
notion of an actual trading band.
The
dollars thus bought have been parked in
low-yielding securities, including short-maturity
US Treasuries and other high-quality debt issued
by various agencies. A contrasting investment in
China's own stock or property markets would of
course have rendered significant returns, not that
any central bank would contemplate such
strategies. Instead, and quite belatedly, China
has begun to take steps that I outlined in a
previous article [2] to expand the return on its
investment pools.
This doesn't mean China
has kept quiet on soft measures to tame its
domestic stock and property markets. It appears to
have employed the services of Hong Kong's renowned
tycoons in spreading the bubble-logic around
China. Two of the richest men in Hong Kong - Li
Ka-shing, chairman of Hutchison Whampoa Ltd, and
HSBC executive director Peter Wong - have recently
spoken about the stock-market bubble, describing
it as a big problem for Chinese. They have limited
impact on the actual trading traditions in
Shanghai or Shenzhen, but will be seen to have
done their part helping the central government in
its quest to tame the markets.
And this
week former US Federal Reserve chairman Alan
Greenspan warned that the Chinese stock market was
heading for a "dramatic contraction" and that the
equity bull run could not last. The market fell
moderately in early trading on Thursday as a
result.
Trojan horses It is
often too easy to get over-excited about things
going on in the financial market. Last week's
subscription of US$3 billion by China's investment
vehicle in the private-equity company Blackstone
set off headline writers around the world, all
wishing to examine the sinister implications of
such a move.
While some argued that China
would use its investment to spread financial
tentacles around the world, others argued that the
US government was doing the opposite to China by
making it throw good money at speculative
investments. Given my past comments on the
mismanagement of reserves by Asian central banks,
which has resulted in billions of dollars' worth
of lost income, the recent move by China should
indeed be applauded. However, what really matters
is how and when China will choose to expand its
returns further in coming months and years.
While I admit that pretty much anything is
possible these day, particularly in games with
stakes set as high as US-China relations, it is
more likely that such commentators are making too
much out of this deal. The amount invested does
look like a nice chunk of money, until one
realizes that it represents less than 0.25% of
China's foreign-exchange reserves - in other
words, less than the interest payments that China
receives on its bond holdings every month.
This leaves us with an alternative
interpretation of China's motives, namely that it
is "paying to play", ie, investing a small amount
of money to understand the investment strategies
employed, pitfalls and costs. With a sufficiently
broad understanding, China could then expand its
investments in such directions as it sees fit.
Indeed, experience suggests that China does employ
such strategies, by first investing money with
professional asset managers in a particular asset
class, and then expanding its own investments in
that asset class over a period of time by first
duplicating the asset manager's strategy and then
fine-tuning gradually.
Sleight of
hand Like a pair of talented magicians
whose elaborate theatrics and extravagant hand
gestures or facetious speeches serve mainly to
distract the audience from observing cunning
sleights of hand, China and the United States are
engaging in various actions that lull observers
into a false sense of comfort. To wit, the
question is not what China and the US are doing,
but rather what are they trying to achieve for
their respective economies.
America's war
economy needs to maintain bubble-like conditions
in the housing market to avoid a recession, while
China needs continued growth in its exports to
fund the excesses being perpetrated in the stock
and property markets. While the central banks of
both countries are queasy about the prospects,
their masters in government are most certainly
not.
However, the Chinese government may
have underestimated the likely motivations behind
the actions of the US Congress in coming months,
and especially the shrill rhetoric ahead of next
year's presidential election. On the former, it is
possible that wider-ranging duties are proposed by
Congress on Chinese goods to serve as a warning of
further trade restrictions.
Meanwhile,
both governments have also underestimated the
impact of the housing and stock-market bubble in
China on policy constraints. As I wrote in the
previous article on abrupt policy changes, China
has for all intents and purposes lost control of
these markets, and must now worry about a mounting
bill for rescuing investors who have bet their
life savings on one, or more likely both, of these
markets. The social problems caused in Hong Kong
during the deflationary years are still too fresh
in Beijing for the risk to be considered. In
contrast, sacrificing some export jobs by letting
its currency appreciate seems like a bargain in
terms of money being spent on workers'
compensation and resettlement.
The central
banks in both countries have lost their
effectiveness. For example, if the Federal Reserve
signals higher interest rates in the US, it will
likely not have a big impact on bond yields,
because of Chinese buying of US Treasuries.
Similarly, any announcement by the PBoC on rate
rises has fallen on deaf ears locally, as
investors continue merrily to pile on the risks by
using money that is recirculated from
currency-market intervention. Thus in both cases
it is China's currency regime that has helped to
propel asset bubbles.
Within all the sound
and fury around financial markets, circumspect
readers should not lose sight of that fact.
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