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5 Liquidity boom
and looming crisis By Henry C K
Liu
actually were dollar inflows,
which could further stimulate an overheated
economy.
Dollar inflows would require
further monetary tightening by the PBoC, on top of
the numerous hikes in interest rates and bank
reserve requirements over the past year, to reduce
the risks of an equity bubble fueled by expanded
money supply. On April 29, China raised the
required bank reserve for the fourth time this
year, reducing the amount
available for bank lending in a new effort to cool
an investment boom that could spark a financial
crisis. The order by the central bank came on top
of successive interest-rate hikes and investment
curbs imposed on real estate, auto manufacturing
and other industries over the past year.
The effort has had only limited success in
slowing the frenzy growth of investment. The
amount of reserves that lenders must keep with the
central bank was raised 0.5 percentage point to
11% of their deposits, from 7.5% of deposits,
before the first increase last June. The increase
to 11% from 10.5% will take effect next Tuesday,
May 15.
The central bank said, "The
increase in bank reserve is aimed at stepping up
liquidity management of the banking system and to
guide a reasonable growth of credit." The Consumer
Price Index rose 3.3% in March, above the Chinese
government's 3% target. And fixed-asset investment
countrywide grew a robust 23.7% during March. The
economy grew 10.7% in 2006, the highest rate since
1995. The central bank said China's international
balance-of-payments problem is boosting excessive
liquidity in the Chinese economy.
China's phantom trade
surplus Chinese global trade surplus hit a
record $177.5 billion in 2006, up 74% from the
previous year. Take away $73 billion of capital
inflow and $60 billion in returns on foreign
capital, and China's net trade surplus was only
about $40 billion in 2006. By comparison, Japan's
trade surplus was $168 billion and Germany's was
$146 billion.
The US trade deficit with
China widened to a record $233 billion in 2006,
out of a global total of $857 billion. If the US
reduces its trade deficit with China, China will
reduce its own trade deficit with its other
trading partners, without much impact on the US
global trade deficit.
Dollar hegemony
distorts Chinese economy The adverse effect
of dollar hegemony on the Chinese economy is
becoming clearly visible. As the
dollar-denominated trade surplus mounts, the PBoC
is forced to tighten domestic macro-monetary
measures to neutralize the increased yuan money
supply resulting from buying up the surplus
dollars in the Chinese economy with the local
currency. The Chinese trade surplus is causing a
monetary bubble in the Chinese economy while real
wealth is leaving China in the form of exported
goods, causing a rising money supply chasing after
a shrinking asset base.
The dollars that
the PBoC buys with Chinese yuan go to finance the
US debt bubble. The new yuan money, instead of
going to finance development of the interior
region in China, is attracted by speculative real
estate and equities, pushing prices up beyond
fundamentals. The Shanghai Stock Exchange
Composite (SHCOMP) rose 27% in a month after a 7%
drop that spooked world markets in late February,
including a 3% drop in the Dow. The Shanghai
real-estate bubble keeps growing in a speculative
frenzy while rural villages are starving for
capital.
China re-exports dollars
Led by China and Japan, all the exporting
economies, saddled with dollars that cannot be
used in their domestic economies without creating
a monetary crisis, are fueling a global liquidity
boom focused on the importing economies led by the
US, where the dollar is a legal tender that
involves no conversion cost. This global liquidity
boom denominated in dollars will cause inflation
in the dollar economy that will spill over to all
other economies.
The US real-property boom
has created huge service demands that lead to
tight labor markets. The global commodity bubble
of the past three years has increased costs of
living and production, adding more than 5% to
global GDP growth. Although commodity inflation
has been absorbed through low-interest consumer
borrowings and lower-wage labor in the past, it is
now finally showing up as higher-cost factor
inputs.
China has kept the global cost of
manufacturing artificially low by not paying
adequately for pollution control and worker wages
and benefits, including inadequate retirement
provisions. Domestic political pressure within
China is forcing the government to normalize full
production cost, which will boost global
inflation.
Financial globalization and
inflation Financial globalization has
increased the elasticity of macro-trends, causing
a delayed effect in inflation. But it has not
banished inflation altogether, nor has it
eliminated the business cycle. It has merely
extended the historical cycle from seven years to
beyond 10 years.
Global inflation has
picked up by 60 basis points in the past four
quarters. If the trend continues, major central
banks will have to focus on fighting inflation by
cooling the liquidity boom. To avoid a drastic
market collapse, anti-inflation measures will need
to be implemented at a "measured pace", which
means it may take as long as two years to take
effect. The problem is that the system, which
operates on ever rising asset values, cannot
weather a two-year-long anemic growth. Thus even a
soft landing will quickly turn into a crash.
Bonds will be the first asset class to
decline in market value in this anti-inflation
cycle, which will eventually also affect other
asset classes. As the flat or inverted yield curve
spikes upward back to normal, making the spread
between long-term and short-term rates wider, the
commodity bubble will burst, followed by the stock
market in a general deflation. Such a deflation
cannot be cured by the Fed adopting
inflation-targeting through printing more dollars
because inflation-targeting is merely transmitting
price deflation to a monetary devaluation.
Globalization and hedging have merely
postponed, not eliminated, cyclical inflation.
Globalization has stunted wage inflation as the
main transmission between monetary growth and
inflation. Hedging only reassigns unit risk to
systemic risk. It does not eliminate risk.
Instead, excessive liquidity fuels asset
appreciation beyond economic fundamentals. To
generate demand from the wealth effect,
appreciated value must be monetized through debt.
As debt rises, systemic risk rises with it. As
globalization spreads demand growth around the
world, inflation has taken longer than normal to
show up in outdated data interpretation.
The burst of the tech bubble, the shock of
September 11, 2001, and the manufacturing and
outsourcing of information technology caused sharp
disinflation in 2002 to neutralize debt-driven
dollar inflation. The average dollar inflation in
the economies of the Organization for Economic
Cooperation and Development (OECD) decelerated
from 3.2% in second quarter of 2001 to 1.1% in Q3
2002. The threat of dollar deflation caused the
Fed to cut the Fed Funds Rate to 1% on July 9,
2003, and kept it there for 12 months until July
7, 2004, while the Bank of Japan maintained a zero
interest rate. This in turn led to a massive
liquidity boom that fed an escalating US trade
deficit.
Before the emergence of dollar
hegemony, through which it became possible to
finance the US trade deficit with a US
capital-account surplus, then-Fed chairman Paul
Volcker had to raise the
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