Because of the lunar New Year festivities when I wrote my newsletter little had happened in China besides the 25 bp interest rate hike on Tuesday, not counting of course the never-ending stream of fireworks and the several really great jaio zi dinners I have managed to snag from my students and their families. I have nonetheless been getting a lot of questions recently about what I expected for the stock market this year.
The first and most obvious question now is whether the latest interest rate hike will hurt the market. I am pretty sure it won’t, except for some of the most obviously liquidity-dependent stocks, like real estate developers. And even then, the increase in rates is too little too late given the surge in inflation. I suspect that when inflation starts to come down, as I think it will by the end of the first quarter or during the second quarter, it should hurt real estate developers more as it more rapidly forces up the real borrowing cost.
In general I think ample liquidity is going to drive stocks higher until at least the end of the summer (assuming of course, perhaps unrealistically, that no more countries unexpectedly fall into default or revolution). But later this year I think a lot of people are going to be rethinking their positions, and investors should be prepared for a rocky end of the year. Why? Don’t forget that the new leadership will be announced in 2012, probably in October, but the actually decision will probably be made much before then, maybe in early 2012.
If that is the case, by the end of this year a lot of insiders are going to be wondering about the policy objectives of the new leaders and whether it is indeed true, as the rumors have it, that they are uncomfortable with the current investment-driven growth model. Any revision of the model will inevitably have big impacts on growth, profitability, and commodity prices.
But until then the market should be strong. Last May I argued that in an effort to keep growth rates high in 2010 and 2011 we were going to see rapid credit expansion in China which, coupled with increases in hot money inflows, would mean tons of liquidity in the Chinese markets. This, I argued, would be very good for the stock markets and for asset markets in general.
Although I was a little early in my stock market call (the market declined for another five or six weeks) other asset markets soared throughout the period. Real estate prices have been on an upward tear, while everything in China that might be considered collectible and capable of holding value – gold, jewelry, premium tea, premium liqueurs, stamps, calligraphy, art, antiques, jade, and so on – has surged in price, in almost every case to record highs.
And in November I experienced one of my favorite indicators of a liquidity-induced bubble: I was speaking at an investor event, and after my standard bearish presentation I was followed by an effervescent partner of a local foreign-owned financial-services company. After explaining graciously that professor Pettis was great on “theory”, he pointed out that he himself preferred to look at “reality” when making predictions (isn’t it always a worrying sign when they say that?).
And from checking out China’s reality (he called it “looking out the window,” throwing in a half-mistaken reference to Keynes) he was pretty sure that Chinese growth was healthy, sustainable, and solid. Talk of a bubble, he insisted, was wrong. And then he produced his trump card. Did we know, he asked the audience slowly and significantly, that Lamborghini was planning to double their sales offices in China this year? With an explosion in the sale of luxury cars how could anyone think there was a bubble?
And by the way its not just Lamborghini – BMW is expecting double-digit sales in China in 2011. With evidence like that how indeed could you think there is a bubble? Yikes!
Yes, Deputy Finance Minister
At any rate I expect China’s GDP growth to be very high this year, and to a lesser extent also expect the local stock markets to put in a good performance, at least until the late summer, although I don’t make a connection between the two, as I explained in an article last June in the Financial Times. I also don’t expect a collapse in the bubble so much as long period of grinding away the investment excesses, accompanied by much, much lower GDP growth numbers for a decade or longer.
But to leave China and turn to the country of my birth, on Tuesday Bloomberg had the following article:
Spain will never need to tap a European Union bailout fund and will succeed in cutting the euro-region’s third largest budget gap and shoring up its savings banks, Deputy Finance Minister Jose Manuel Campa said.
“We’re fully convinced that we’ll never need” an EU rescue, he said in an interview with Andrea Catherwood on Bloomberg Television’s “The Pulse.”
…“For the first time in three years, I’m starting to see the light at the end of the tunnel for our country,” Francisco Gonzalez, chairman of Banco Bilbao Vizcaya Argentaria SA, told a news conference in Madrid today.
I suppose it is a little invidious for me to mention that the first time the phrase “light at the end of the tunnel” was used in conjunction with the economy was by President Hoover in 1931. Its probably even more invidious if, in responding to Campa’s promise that Spain will never need to be bailed out, I quote one of my favorite British comedies. “The first rule of politics,” Sir Humphrey, the wily civil servant in Yes Minister, insists is: “never believe anything until it is officially denied.” Yikes again!
The Bloomberg article lists Spanish debt as being equal to 64% of GDP and quotes Campa as saying that Spain will “make good on its pledge to get its deficit down to 6 percent of gross domestic product this year.” Campa also says Spanish savings banks, or “cajas”, will fare well in a new round of stress tests meant to expose any weakness in capital levels.
Maybe, but my admittedly anecdotal evidence while I was in Spain suggests that there was so much incredibly foolish lending into real estate over the past decade or two that I would be very surprised if a correct accounting of contingent liabilities in case of any serious disruption did not cause those debt numbers to soar, even if the government succeeds in keeping the fiscal deficit down to “merely” 6% of GDP. I expect that this year we are going to start seeing serious political resistance to the steps needed to bring debt numbers to manageable levels.
I wrote about this three months ago when I argued that the process of assigning the costs would almost certainly cause a radicalization of European politics, and the longer it went on the more radicalized it will be. So check out this article in Monday’s Financial Times:
There has “never been a greater need for republican politics”, said Gerry Adams, president of Sinn Féin, as he set out his party’s distinctive policy pitch for Ireland’s general election later this month. The country’s centre-right Fine Gael and centre-left Labour parties – which polls suggest will likely form the next government – say they will seek to renegotiate parts of the €85bn bail out with the European Union and International Monetary Fund.
But Sinn Féin – once best known for its links to the Irish Republican Army – will go further, Mr Adams told reporters at the launch of his party’s campaign on Sunday. It promises to reverse the budget cuts, impose losses on the international bondholders who lent to Ireland’s crippled banks, and tear up the EU-IMF deal. As voters absorb the cuts announced in December’s austerity budget and look to the left, the party is well placed to capitalise on Ireland’s economic woes in the February 25 election.
Now of the many topics about which I know absolutely nothing, Irish politics may well be near the top of the list, so I will try not to read too much into this, but it is pretty clear to me that over the next few years we can expect a bull market for radical political parties and radicalized factions within the main political parties. I have lived in Spain long enough to suspect that the Spanish (and the Portuguese and Greeks, for that matter, not to mention other countries), are not likely to fall behind the Irish when it comes to political anger.
How will the politics evolve? To answer I can only turn to Lewis Carroll:
“That depends a good deal on where you want to get to,” said the Cat.
“I don’t much care where—“ said Alice.
“Then it doesn’t matter which way you go,” said the Cat.
“–so long as I get somewhere,” Alice added as an explanation.
“Oh, you’re sure to do that,” said the Cat, “if you only walk long enough.”
This is an abbreviated version of the newsletter that went out Tuesday. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please. Investors who are clients of Shenyin Wanguo Securities will already receive the newsletter. Investors who are not clients but who want to buy a subscription should write to me. also at that address.
Michael
Is it wrong to assume that most economic shocks happen outside of the control of most policy makers? Chinese leaders may not have a choice when people begin to slow investment into the country. Is this right or wrong?
http://www.bloomberg.com/news/2011-02-11/south-korea-s-yoon-sees-doubts-over-currency-reserve-system.html
What is the alternative in the long term? Cut throat competition in a true free market system? of course we would also have world peace and no more disease
The chart of the Chinese inflation rate up to 2008 tells the story. Inflation reached over 8% and was rising strongly when the financial crisis hit. That tells me that the policy mix that worked so well for China was ceasing to work. China could not longer have ~10% growth with controlled inflation. The big price drop in oil, food and raw materials in 2008-2009 created the headroom for the huge stimulus as inflation fell but that era is now over. There is no real basis to assume that 10% growth can continue without inflation continuing to accelerate. China really needs a new policy mix now, combines a new growth target of ~5% with a rising exchange rate to reduce imported inflation.
Further to my comment above, people have a touching faith in Chinese economic management, but bringing inflation down must hurt from now on which will not be good for equities. For 15 years central bankers have promised that painless (25 bp) tweaking of interest rates is all you need but that was based upon a deflationary China price. Now the China price is inflationary so painfully less GDP growth is the cure. Your bearish call for H2 looks good to me but I think it will extend beyond China. Market interest rates are rising everywhere so cash looks king from the summer onwards.
Yes, it’s worrying when an economist or stock picker in a debate says “The reality is….” Not because theory is more important, but because someone using trite rudeness is not likely to know good theory.
Michael,
I have another question on the timing of adjustment in China. In a prior response (thank you), you said that the timing is in the hands of policy makers as long as there remains capacity to take on new debt.
In our bubble, this was all very clear. We went through the various levels Minsky outlined until even the the interest payments couldn’t be covered except through the taking on of new debt. I believe that at the peak, the average subprime mortgage in California was repaid within a year. Policy makers watched the show from the sidelines until we hit the brick wall, which was the consistent falling in home prices.
But in China’s part command/part market economy, even if you had access to credible statistics it would be very hard to determine even what the brick wall would be. If policy makers don’t deliberately stop it, couldn’t it go on, ever more inefficiently and opaquely, for years and years?
In a way, it seems more like the Soviet Union in the 1970s than Japan in the 1980s. When did the growth in the Soviet Union evolve from sustainable but flawed to completely unsustainable? 1967? 1974? Who knows?
Dr. Pettis,
This link needs to be fixed. It goes to your own article mentioned in the preceding sentence:
So check out this article in a Monday’s Financial Times:
The question for me is how can social unrest modify politics these days. Populism is rising in Europe, but what will be the consequences? In Spain, some social movements that focus their anger against financiers are arising, but they are small rigth now. The number of evictions in Spain is rising but slowly due to judiciary bottlenecks. Unemployment rates rise again this year thanks to fiscal consolidation measures.
Yes, I see social unrest coming as a slow and profound tide, but I completely ignore what will be the consecuences of it, if any.
more anecdotal evidence:
Today I spoke with a young girl (student at my business school), she told me shad had investwed 30.000 EUR two months ago, and made 20.000 EUR gain in Chinese stocks
I dont know how she did it.
I advices her to atleast take the profit and put it in Yuan. She said no, because the inflation was too high. Then I told her that even though shem might have negative interest rent, her Yuan might appriciate against other currencies and in the long term turn out to give her increased PP abroad. She still kept to her stocks, wanting more gains….
we didnt have time to discuss more…
eargerg ergergre yrd
This is not the first time you have mentioned you expect a rise in “radical politics” but you never define what you mean by that. I assume you mean something outside of the political concensus that has dominated the western world for the past few decades. I understand why you might think this with unemployment rising so dramatically and so many countries having to implement what are always called “harsh austerity programs.” But I do not understand how that automatically leads to radical politics that will have any significant implact.
Our old friend V. I. Lenin knew that effective political action did not arise spontaneously but rather required organization and of course leadership.
His model was very effective and brought about radical political change in many parts of the world for the better part of the twentieth century.
So where is the organization and leadership that will bring about this radical politics? I doubt it is in the unions, as they are increasingly representative of their educated and aging membership who have little to gain by a turn to radical politics.
I doubt it is among the greens who are dominated by educated and middle-class idealists who have little in common with the unemployed and frequently no inclination to compromise for political gain.
There is probably some potential among nationalist parties that choose to campaign against immigrants, elites or central governments whether in Madrid, Brussels or Berlin. You mention Sinn Fein as one example and I suppose Catalan and Basque nationalists might benefit in Spain. In other countries the anti-immigration parties have been making small breakthroughs but are still marginal political forces.
Maybe the radical political organization and leadership will come from the roving bands of anarchists who disrupt G20 meetings and occassionally disrupt the internet. But their appeal is limited, their agenda usually unclear and, as Lenin well knew, their organizational ability limited.
Paul W – what would V. I. Lenin have made of Friday’s events in Egypt? Was that not “effective political action”, and was it not spontaneous and without organization or leadership? To deny these things is to invite tautological definitions.
Quite simply, Lenin was wrong. Modern math and sociology has chiseled away a bit at the underlying phenomena; see the work of Duncan Watts for the theory, John Robb for the practice.
When the cascade activates, there is no way to predict what will happen. Potential cascades are hard to detect and stability is sometimes illusory – the process of “assigning costs” will result in policy errors, the result of the overestimation of stability. Policy errors, combined with “noise” – some damn fool thing is always happening, everyday – will set off cascades.
Michael, If Ireland takes the path of giving bondholders a haircut and Spain, Portugal and Perhaps even Italy follow suit, is it Germany that that is going take the loss?
I also want to ask you, or any other posters here, is it correct to automatically include China’s inflation in determining relative currency values?
Fred Bergstein states ;
There are encouraging signs that a breakthrough may have been achieved in the long-running debate over the exchange rate of China’s currency, the renminbi. Its real rate against the dollar is now rising at an annual rate of 10 to 12 percent, which if continued would complete the needed correction of 20 to 30 percent over two to three years, and official US reactions suggest that assurances that the adjustment will continue may have been received. This movement appears to derive from effective US pressure, increasing expressions of concern about the issue from other countries (especially a number of major emerging markets) and, most importantly, changes in economic conditions in China itself.
The nominal exchange rate of the renminbi has now appreciated by about 3.7 percent against the dollar since China announced last June that it would let the rate start moving upward again. During this same period, Chinese inflation has accelerated and is running substantially above that of the United States (which is less than 2 percent). Different indexes produce different results and all of the official numbers probably underestimate the actual pace of upward price movements in that country. It is safe to say, however, that the real exchange rate of the renminbi has risen by at least 5 percent against the dollar over the past seven months, producing a real appreciation against the dollar at an annual rate of at least 10 percent and perhaps as much as 12 percent.
————snip
My understanding is that only part of inflation effect has materialized in earnings. As such, part of the inflationary pressure has been realised, part of it has has been absorbed by Chinese workers in the form of reduced purchasing power. Is that correct?
Why beating a dead Spanish horse when China’s trade numbers are so intriguing?
RS, yes economic shocks happen outside the control of policymakers, but the way those shocks are absorbed into the economy typically depends on the structure of the banking system, and Beijing pretty much controls the Chinese financial system (with one important caveat, which is the quite-large informal banking system). For me the key is the perception of debt capacity. Once Chinese businessmen begin to believe that debt capacity limits have been breached, then indeed we will see disinvestment and flight capital, and Beijing will have no choice but either to let the economy slow sharply or to use debt to keep growth high. Most policymakers historically have tended to choose the latter path, but of course this is the worst possible path because it only exacerbates the debt capacity problem.
Alan, you may be right, but my instinct is that inflation will probably begin to moderate in the next quarter. Weirdly enough there is an argument to be made that inflation could be good for China because it will force them to adjust interest rates and so improve the problem of capital misallocation 9assuming they raise rates as quickly as inflation rises).
Scott, I don’t mind rudeness. The problem is that without a theory to guide you it is meaningless to look at facts. There is an infinite number of facts, but you need to put them into a coherent and logical explanation of the underlying reality, and that requires a theory or model. When someone tells me he prefers facts to theory, I just assume he can’t grasp either.
Bob, you raise an interesting question. In my experience opacity is a self-reinforcing factor. When confidence is high, lack of information allows you to imagine good outcomes and so reinforces your confidence, but when confidence declines evaporates the opposite happens. I think this is part of what Rudiger Dornbush meant when he argued that in developing countries the crisis always came much later than you predicted and was always much worse than you expected.
Don’t we all, Ignacio. It is very hard to predict how social discontent gets translated into politics. In Spain it may very well show up as increased agitation for regional autonomy, or it may cause a revival of the extreme left- and right-wing parties that were more visibly just a couple of decades ago. In France the head of the National Front is currently recording the highest personal approval ratings in National Front history. The only thing I think that we can say with certainty is that as the political consensus gets fragmented and as ruling parties or coalitions have to fight harder to maintain their power, there is a rising incentive for short term solutions over long term ones.
Paul, perhaps “radical” is the wrong word. I am expecting a more fragmented consensus and political instability. And as Lewy14 points out, I am not sure I would turn to Lenin for the only explanation of political instability.
Glenn, as of now the haircuts would be absorbed primarily by French and German banks (and hence households). As for your second point, I just had a discussion about that over lunch with some US Treasury people. I think we have to be careful assuming that X% inflation is the same as X% nominal revaluation. It depends on the relationship between overall inflation and inflation in the prices of inputs for the tradable goods sector. My guess is that there has been very little inflation pass-through into exports, and if you look at the dollar price of Chinese exports to the US, they have gone up by far less than the amount of the currency revaluation. I wrote about that extensively in the full version of the above entry.
Ha ha Rien you hate when I express my skepticism about Europe’s prospects, but you have to admit Europe is still very interesting. I didn’t write about China’s trade numbers because I didn’t want to trot out what I have been saying for two years. To me the trade numbers introduce nothing new for me in my way of thinking.
lewy14
Maybe you are too young to understand Lenin..On the other hand, trouble has a way to find a way and troublemakers are easy to find.
Michael, do you feel that the Treasury is assuming that X% inflation is the same as X% nominal revaluation due to eventualities? That once the capacity to absorb, via reduced PP of Chinese citizens, is utilized that the full effect will pass through, making the point moot?
Michael,
This doesn’t have to do with your topic, but it’s relevant to an evaluation of the soundness of the banking system: http://www.nytimes.com/2011/02/18/world/asia/18rail.html?_r=1&partner=rss&emc=rss
“A person with ties to the ministry said that the concrete bases for the system’s tracks were so cheaply made, with inadequate use of chemical hardening agents, that trains would be unable to maintain their current speeds of about 217 miles per hour for more than a few years. In as little as five years, lower speeds, possibly below about 186 miles per hour, could be required as the rails become less straight, the expert said.”
I’ve read similar complaints about the quality of high-rise building construction.
There is this investment boom, but how long will the payoff period be?
interesting article of the NYT. that perhaps explains why the stock related to high speed railway are not skyrocketing anymore in the Shanghai bourse !
Prof Pettis
Actually, it’s not surprising how many live in denial town, perhaps it is easier to look at the green hills in the distance rather than the perilous cliffs one is walking on, vertigo after all may just bring about the fall more rapidly. Well, look on the bright side, the effervescent partner of a local foreign-owned financial-services company and the likes of him mean there is still a market for whatever assets you might wish to dispose of before the fire alarm goes out, unless of course they are pulling moves similar to a certain french bank in 2007/8. As for being off on the timing, well, you probably won’t have to wait as long as roubini did for his 2008.
As for politics, remembered being the joke of the month for my comment that the millennium may well prove to be a hotbed for extreme socialist sentiments even as we barely finish celebrating the end of communism as a force in the 90s. Things will get ugly across Europe, the only question is how ugly? Personally, I think how ugly things get in Italy will be a barometer for how much civility will be left in the rest of Europe, after all, if the placidity of those resigned to certain things in life and politics is destroyed, the rest of Europe won’t be looking at much peace for a long time.
rof Pettis
Actually, it’s not surprising how many live in denial town, perhaps it is easier to look at the green hills in the distance rather than the perilous cliffs one is walking on, vertigo after all may just bring about the fall more rapidly. Well, look on the bright side, the effervescent partner of a local foreign-owned financial-services company and the likes of him mean there is still a market for whatever assets you might wish to dispose of before the fire alarm goes out, unless of course they are pulling moves similar to a certain french bank in 2007/8. As for being off on the timing, well, you probably won’t have to wait as long as roubini did for his 2008.
As for politics, remembered being the joke of the month for my comment that the millennium may well prove to be a hotbed for extreme socialist sentiments even as we barely finish celebrating the end of communism as a force in the 90s. Things will get ugly across Europe, the only question is how ugly? Personally, I think how ugly things get in Italy will be a barometer for how much civility will be left in the rest of Europe, after all, if the placidity of those resigned to certain things in life and politics is destroyed, the rest of Europe won’t be looking at much peace for a long time.
Michael,
“Ha ha Rien you hate when I express my skepticism about Europe’s prospects, but you have to admit Europe is still very interesting.”
Of course! And maybe we will have a few mad Irishmen tomorrow who will cause a new bout of unrest (not to mention the Hamburg State election). But curiosity may be more appropriate than scepsis here.
Incidentally, it is very European (= un-Asian) to be sceptical about one’s “country”‘s prospects.
I merely mentioned the trade figures, because a very respectable US economic blogger (Scott Sumner) went outside his area of expertise and wrote that the narrowing of the deficit was significant, especially via a rapid increase in imports. I share your views re trade figures, and the only thing that is somewhat significant is a very strong export performance, but, Lunar NY etc.
Prof Pettis
Apologies for the duplicate post(29), please remove it if possible.
Huizer
Incidentally, it is very European (= un-Asian) to be sceptical about one’s “country”‘s prospects.
Really, would never have figured the Japanese to be particularly “European” in nay way!
LOL!
Europe looks headed for more Pieter Bruegel scenes than Impressionist and yes, aren’t we lucky to live in interesting times.
Judy,
Your remark about the Japanese made me do some scholarly work and what did I find? In the Dutch East Indies (the country most people call Indonesia these days, although you still find older people in Holland who ignore that change) anyway, to make a long story short, in the old Dutch East Indies, after WWI, the Japanese were officially considered “Europeans” (as different from indigenous people and people from elsewhere in Asia (mainly ethnic Chinese). And you see, even today the Japanese live up to that. Cause and effect..