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WHY A CHINESE MONETARY TIGHTENING COULD BE FOLLOWED BY A GLOBAL DEPRESSION
by Thomas P. Au, CFA, Author & Market Analyst
May 23, 2007
http://www.financialsense.com/editorials/au/2007/0523.html

As the world’s largest holder of dollars, the People’s Bank of China is now the world’s de facto central bank. That’s a scary thought because China is a nouveau riche nation that is not ready for a principal role in global economy. But in 1929, the United States was similarly a parvenu, a country that held 50% of the world’s monetary reserves (in the form of gold) even though its central bank, the Federal Reserve Bank of the United States (or Fed for short), was all of sixteen years old; this adolescent outfit had been created only in 1913 after the passage of the 16th Amendment to the Constitution.

Moreover, China is facing the essentially same dilemma today as America did in 1929. The United States in the 1920s flooded the world with liquidity in order to hold down a fundamentally strong dollar and prop up a weak pound at the behest of Britain’s central banker, Montague Norman, and a Treasury Minister named Winston Churchill (who failed at everything he did in public life before winning World War II). China has been similarly accommodative until recently to support the weak U.S. dollar, despite making heroic efforts to “sterilize” these dollars. But some of the liquidity inevitably found its way into the Chinese and global economies, helping to bring about torrid (and probably unsustainable) double-digit percentage growth in China.

This growth is also taking place in a relatively unbalanced fashion. For instance, Chinese consumer spending growth is only about half of industrial spending growth—in the mid-teens. The high single digit percentage difference has to be made up by exports, which led to the problems just alluded to, large trade surpluses for China, and large trade deficits for the United States, causing major imbalances for both countries. If the trend continues, via more deals like Chinese buying of a $3 billion stake in Blackstone, they could become “Siamese twins,” (the original of whom were literally ‘joined at the hip’ and impossible to separate without killing one or the other). More likely, “excess capacity” in industrial goods would lead to an economic bust in China, at about the same time that the U.S. came from downward pressure on consumer spending because of the collapse of the housing bubble.

Such runaway growth is also threatening to overwhelm China’s relatively primitive commercial and physical infrastructure. The country has some of the most modern industries in the world, side-by-side with Stalin-era state-owned enterprises (SOEs)—and a banking system that has to serve both sectors. Accounting is equally sporadic, state-of-the art in a few instances, archaic in most others, meaning that only a few companies can be really sure about what they are earning. World-class economic officials exist at the highest levels of the government, alongside corrupt local bosses that threaten to derail the economy for their own ends. And even the smooth functioning of basic utilities can’t be taken for granted, given periodic brownouts in major cities.

As a result, the Chinese stock market is waking up from a long slumber. One to two million brokerage accounts are being opened every week in China. Even with a population of 1.3 billion, 100 million brokerage accounts a year would mean that 50% of China’s population would have such an account only six and a half years from now. (It took over a century for America to achieve that level of penetration.) What’s more, these accounts are being opened by all the usual suspects of a market top, “cab drivers, house cleaners, college students, and Buddhist monks,” according to Adam Shell of USA Today. Meanwhile, Chinese stocks are now selling at 30 to 40 times earnings, bubble levels. And the passage of new legislation to allow Chinese to invest overseas, may give a temporary lift to other markets including that of the United States. That’s not a comforting thought, given the lack of sophistication of investors like those just noted, because the change of stock ownership that we’re now seeing is called “distribution.” We’ve seen this movie before.

It’s easy to say with the benefit of hindsight that the U.S. Fed erred in keeping monetary policy too tight in the 1930s. But that came about because the Fed was too loose in the 1920s, as has been the case in the 1990s, and so far this decade. And the most immediate threat in the Western world prior to 1929 was the German hyperinflation of the early 1920s (which destroyed the German economy and middle class and ultimately brought Hitler to power). It was in avoiding the Scylla of such inflation, that the Fed opted for the Charybdis of deflation; in tennis lingo, that was a “forced error.” China had a similar, and first-hand, experience with hyperinflation in 1949; more than anything else, it brought the present (Communist) government into power. With that heritage, China is going to err on the side of tightness. In fact, the country is using all three major monetary tools, open market operations, raising discount rates, and raising reserve requirements in a concerted effort to cool down its economy. Such a confluence of policies is seldom seen in the western world.

It’s possible that a more seasoned Fed in the 1930s might have barely avoided the depression that resulted from the 1929 crash. But to hold the 1930s Fed to the elevated standards of today would have been too much to ask. (When was the last time parents you know tore out their hair because their sixteen-year old was incapable of acting like an adult?) Likewise, more experienced hands at the helm of the People’s Bank of China might possibly avoid the oncoming bubble and crash. But that is asking a lot of an institution and country that are just beginning to make the transition from Communism to capitalism.

The problem with experience, someone once said, is that it comes along only after you need it most. The American central bank has experience, but it’s not the one needing it. The Chinese central bank is now in the driver’s seat, and hasn’t yet had experience come along. It’s about as seasoned today as America’s Benjamin Strong-led Fed was just before 1929. More to the point, it’s not about to listen to the U.S. because we are a major part of the problem in other respects.

I believe that China is setting a massive tightening of the global money supply in progress, and that this tightening could soon be followed by a global depression. Either event may happen or ultimately fail to happen. But in either case, it is basically out of America's control. Like a lot of other goods that Americans now import, the modern 1929 (or a somewhat better outcome), will have been “Made in China.”


© 2007 Thomas P. Au
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Thomas P. Au
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