Wrangling with the Wild Bulls


A double digit–growth rate and a howling one-third increase in property investment. Recent statistics, though far from accurate, unambiguously show an overheating Chinese economy as well as a speculative bubble. Consumption inflation is also likely to head towards double digits soon, even though official statistics still portray low inflation.
Some sort of crisis may already be inevitable. But, by delaying remedial action, trouble, when it arrives, will only be bigger.
Anecdotes point to a significant expansion of the property bubble. Property speculation picked up speed right after the National People's Congress meeting. Both prices and volumes rose sharply in major markets like Beijing and Shanghai. Speculators lost their fear, while the fear of inflation seized savers. No one believed the government would let property prices fall. As a result, people have been withdrawing their savings and borrowing as much as possible to buy property, regardless of the price. This is all similar to the final frenzy in financial mania. If the experiences from other countries are anything to go by, this frenzy could expand the size of the bubble dramatically. The consequences may well be catastrophic – as Japan showed 20 years ago, Southeast Asia 10 years ago, and the US is demonstrating now.
The latest measures aimed at tightening property are technical in nature and target speculative demand. But, like similar measures in the past, they can be circumvented. Further, prolonged negative real interest rates – that is, rates below inflation – are the driving force of the bubble. Unless this is corrected, after a brief pause, the bubble will grow big again. Such a vicious cycle only ends when banks have insufficient liquidity – that is, households don't increase their deposits but want to borrow as much as possible. Indeed, recent data suggests this scenario is coming.
The most effective actions for containing the bubble are: one, raising interest rates to above the expected inflation rate; and, two, raising capital requirements for banks. China should quickly raise interest rates by 2 percentage points; current rates are ridiculously low. When this is the case for too long, it leads to a property bubble, resource misallocation, and, eventually, a financial crisis.
China's interest rates are probably five percentage points too low. Yuan appreciation expectations have provided money holders with a substitute for interest rates. Indeed, such expectations have driven up yuan demand so rapidly that the central bank has increased its foreign exchange reserves three times, to US$ 2.4 trillion, in the past five years. China's asset prices have risen by about the same magnitude. Inflation has followed.
China's currency appreciation may have largely occurred through inflation, despite what the statistics say. The evidence is that, first, exporters are looking to shift more production to other countries and, second, China's price levels are very high in an international comparison. Much of the currency–appreciation expectation today may be a bubble. It remains strong because, for hot money, China is still the land of rising asset prices. The most effective way to deal with these expectations could be to cool the asset bubble at home. Hence, raising interest rates might repel some hot money.

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