Yesterday we posited that the market might be topping out. Not in the way it did in 2007 though. This topping process may be far more subtle and dangerous.
Back in the heady days of the credit boom, nearly all markets were reaching record highs at the same time. Now, after the bust, some have recovered better than others. The ‘topping out’ thesis is not so uniform.
What we mean is that the liquidity-induced recovery in the global economy, and equity and commodity markets, may be coming to an end. Not as in running into a brick wall, but a slow dawning on investors that all is not right in the world.
The data out of China yesterday heralded the first light in this dawning process. Economic growth came in at 9.8 per cent during the fourth quarter of 2010, or 10.2 per cent for the full year. This was higher than expected. It means interest rates will probably rise again to combat inflation.
Officially, the inflation rate is 4.6 per cent. Unofficially, it’s probably much higher.
Global equity markets, and commodities in particular, are selling off on the news. The topping out process has begun, but its likely to confuse and confound.
Because China’s interest rate rises have so far done little curb the credit boom. More tinkering around the edges will do little to stop the runaway growth in credit. This current correction could well be the pause before the final speculative blow-off.
We don’t know of course, but there are some parallels here with the US housing bubble. We’ll get to that in a moment.
But back to China’s credit boom. It was mandated by the government as a way to get out of the 2008 recession. They ordered banks to lend.
Don’t worry about assessing risk, just get the money out into the economy. China’s central planning bureaucrats unleashed the animal spirits of the Chinese population and now they’re having trouble getting the leash back on.
China’s M2 money supply is running at an annual rate of 19 per cent. This is down from the peak of nearly 30 per cent in late 2009 but at twice the rate of economic growth, it’s still very strong.
Lending growth figures are similar. After peaking at around 35 per cent in late 2009, in the year to December 2010, official figures show Chinese banks grew their loan books by 20 percent. This doesn’t include off-balance sheet loans, the size of which could be significant.
And according to recent reports, lending in January is off to a cracking start. The bottom line is that raising interest rates by a piddling 25 basis points will do little to curb speculation in China when real rates are already deeply negative.
Take a look at what happened in the US prior to its bust in 2008. Interest rates were at 1 percent up until June 2004 when the Federal Reserve began to raise rates ever so slowly. By the end of the year they were at a still low 2.25 per cent. Meanwhile, the housing boom was gathering pace.
During 2005 the Fed raised rates another eight times (in 25 basis point increments) to 4.25 percent. In 2006, the year the housing bubble peaked, rates went up four more times to 5.25 per cent.
They stayed at that level for over a year. The Fed stayed well behind the curve too. In September 2007 they finally realised what was going on (well, sort of… at the time troubles in the housing market were still ‘contained’ weren’t they?) and cut rates by 50 basis points.
By that time it was too late to do anything. The boom had been, ensuring a bust.
Now getting back to China, what do you think they could learn from the US’ experience?
What do you think they will learn?
Correct and correct.
If China wants to avoid a hard landing, they should ensure that their money supply and lending growth doesn’t continue to get out of hand. This means tighter monetary policy now.
But that is unlikely to happen. China’s communist leaders are no different to America’s capitalist leaders. They want to hang onto power. You do that by prolonging booms, not truncating them.
In an opinion piece in the FT, Jonathon Fenby summed up China’s predicament nicely.
‘It may seem strange that a one-party regime finds it so hard to put the growth dragon back in the cave after letting it roam free over the last two years. But Mr Wen and Communist Party leader Hu Jintao, who is currently on a state visit to the US, operate by cautious consensus. If the December data are anything to go by, they are going to have to toughen up their act. Failure to do so and they risk being remembered as the men who, for fear of a hard landing, proved unable to control the factors driving China’s rise.’
History suggests China either risks a hard landing now, or defers and ensures an even harder landing down the track.