Jun 27, 2013 02:52 PM

When the Tide Goes Out

The liquidity crunch in China's financial system reflects pressure on hot money-fueled speculative practices from hot money leaving. The central bank is not in a position to inject liquidity to replace all the departing hot money. Because the Federal Reserve is likely to tighten for three years to come, printing money to replace all the hot money that is leaving would put the country's exchange rate under mounting pressure to devalue, which may trigger a full-blown financial crisis.

The demand for money from the country's financial sector has been mainly for financing speculative leverage in the land market and local government debt. Increasing the money supply merely boosts speculation, not the real economy, as the experience in the first half of 2013 demonstrates.

The bursting of the speculative bubble has had a limited negative impact on the livelihood of the people. China's position as the factory of the world is solid. The export weakness is due to weakness in global demand, not competition. As exports are still rising at twice the pace of global trade, China's economy has a solid cushion from any downturn.

The country is experiencing an acute shortage of manual labor. If the property market contracts, it won't lead to widespread unemployment. College graduates are having difficulty finding jobs, but, this is mainly due to the current economic model, which drives growth through construction and factory production. Only changing the growth model can solve China's problem with insufficient white-collar jobs.

Many small and medium-sized enterprises (SMEs) claim they cannot survive without more loans. A healthy SME does not expand when it cannot obtain more funds. But, surviving on debt implies that it is a loss-making business to begin with. Such businesses should close. Propping them up merely postpones a financial disaster.

The central government could issue a supplementary budget, financed by fiscal bonds, to address acute livelihood issues, like food safety, clean air and water. It could build another cushion in the economy and ease social tension at the same time.

As asset prices adjust, there will be mounting pressure on the central government to bail out the markets. Doing so would inflict enormous harm to the country's economy over time. This could lay the foundation for a total financial and economic collapse in two to three years. The central government should resolutely maintain stable monetary policy.

Indonesia printed money to finance capital flight in 1997 and 1998. The country collapsed afterwards, bringing down the government and the banking system. China must learn from this lesson and control money supply.

In 1998, China refused to print money and devalue. It reformed to deal with the pressure, which gave the country a decade of economic boom. The same could happen now. Just control money supply and reform to handle economic difficulties. China would have another decade of prosperity ahead.

The Tide Recedes

Since the Fed began to talk about tapering or decreasing quantitative easing, global financial markets have been responding by cutting leverage and shrinking exposure to high risk assets. Emerging markets, as usual, suffer fund outflows first. The currencies of major emerging economies like Brazil and India have depreciated substantially, down one-fifth from their peaks, to reflect the outflow pressure.

Since the yuan is de facto pegged to the dollar, the outflow is greater than what Brazil or India faces, as hot money outflow is not discouraged by a lower exchange rate. The hot money in China's financial system probably exceeds US$ 1 trillion dollars. The country's total money supply, or M2, is 104.2 trillion yuan or US$ 17 trillion. If all the hot money leaves, the squeeze will be significant. However, it should be viewed in the overall context. China's money supply is likely to rise US$ 2.5 trillion in a few years. The outflow merely decreases the growth in money supply. It will not contract. A normal and healthy financial system would easily absorb a blow of such magnitude. The struggle of the country's banks under a little pressure shows that they have not been prudently run. There has been too much financial leverage to support speculation.

Too Much Speculation

The country's M2 is rising above 15 percent per annum. Its current growth rate or potential growth rate is not even close. The monetary policy is still loose. Further, the rampant monetary growth is losing impact on the real GDP growth rate. M2 rose by 6.1 trillion yuan and the net increase in all sources of financing rose by 6.2 trillion yuan in the first quarter of 2013. But the nominal GDP increased by only 1.1 trillion yuan from the year before. It is obvious that most demand for money is not from the real economy.

The country has been experiencing a vast property-cum-credit bubble. This bubble has become so big that sustaining it requires twice as much money as the real economy needs. Right now, for every three yuan of monetary increase, two go toward sustaining the bubble. The ratio will only increase, as more ways for leveraging up are created.

For example, a property company may have four layers of leverage. A project would have a bank loan and sub debt. The land is pledged to a bank for a loan. A trust company may provide sub debt with the leftover land value as collateral. The holding company will have bonds, backed by corporate cash flow, not any specific collateral, issued onshore or offshore. The shareholders of the company will have another layer of debt with the shares as collateral.

The financing market will build up more leverage. The trust loans could be packaged together, sliced like the collateralized debt obligations in the United States, and sold to investors who look for high interest rates. These investors could obtain another layer of leverage by buying such products.

Two risks – fake liquidity and term mismatch – have mushroomed in the financing market for land-backed local government debt. Through packaging some assets into a fund and selling to numerous retail investors, liquidity is manufactured through retail investors coming in and dropping out. It manufactures the perception of liquidity. Because the underlying assets are not liquid, the market freezes up as soon as the perception about the value of the underlying asset changes.

Many, if not most, financial institutions have been selling short-duration financial product backed by longer term assets. For example, a three-month product may promise a 4 percent annualized return. It may deploy the money in bonds with an average maturity over one year or longer. The issuer is not worried about what happens when the three months are up. It assumes that it can issue another three-month product to take over. The issuer profits from a positively sloping yield curve.

The above two risks make the financial system especially vulnerable to a liquidity squeeze. This is what has happened in the past few days. As hot money leaves China, the short-term liquidity dries up. The financial system depends on such liquidity to roll over its products. It freezes up for the time being.

No More Room

As hot money leaves China, the financial system faces a squeeze at the short end of the liquidity. The current system is most vulnerable to just such an event. Instead of learning from its the mistake and cutting leverage to decrease dependency on such liquidity, the system seems bent one pressuring the central bank to inject enough liquidity to keep the game going. If the central bank replaces all the departed hot money, it merely postpones the day of reckoning for the leverage bubble and puts the whole country at risk of a financial collapse.

China's speculative bubble has been holding hostage the real economy and the central government. Whenever the bubble wobbles, talk of economic collapse dominate the media. The situation now is no different. The reality is quite different. I will analyze below. Such behavior threatens to destroy the country's economy over time. If the central government gives in and prints more money to support the bubble every time it wobbles, the monetary excess will grow exponentially. When it blows up, the currency collapse and the resulting hyperinflation will destroy the economy.

The speculative bubble centers around land and local government spending. Because most lending is backed by land directly or indirectly, the health of the financial system depends on how real land prices are. The national average for land prices may have risen over 30 times in the past 10 years. In some hot spots, they have gone up over one hundred times. By most measurements, land prices may be two to three times overvalued. This implies that a significant portion of financial assets are bad. Only rolling liquidity covers up the extent of non-performing loans in the financial system.

The dominant view in the bubble economy is that the only way forward is to keep pumping liquidity and rolling everything over. Kicking the can down the road cannot continue forever. The current global environment makes it difficult now. As the Fed embarks on tightening, hot money is leaving. As leverage in the global financial system declines, the liquidity just vanishes. If China insists on pumping liquidity to replace the outflow of hot money, it encourages capital outflow by holding up asset prices artificially high. As its money supply is five times the country's foreign exchange reserve and the annual growth in money supply alone is two-thirds of forex reserves, replacing capital flight by printing money can go disastrous quickly.

In 1997-98, Indonesia did just that. It even borrowed lots of money from the International Monetary Fund to finance capital flight. When the U.S. dollar reserves dried up, the currency and the financial system collapsed. When a country faces what China faces now, it can either raise interest rates or devalue the currency. Avoiding both just creates a bigger disaster.

China must tolerate some rise in the short-term interest rate. It will force out the leverage that profits from term mismatch in wealth management products. The yield curve may need to stay inverse for some time. It is necessary. If the central bank pumps liquidity to restore the positive slope in the yield curve, it will lead to a catastrophe down the road, possibly within a year.

Financial Deleveraging

The country's economy is in a good position to handle the unwinding of the leverage bubble. Its position as the factory of the world is solid. Even though exports are slowing, they are still rising twice as fast as global trade. The household sector has low leverage and a high savings rate. The consumer sector is robust. The two pillars support the economy during any domestic financial turbulence.

More importantly, the labor market is resilient. There is a widespread shortage of blue-collar labor. If the property market slows, it will not lead to widespread unemployment. Indeed, some slowdown will ease the inflationary pressure in the labor market, which would support financial stability.

College graduates do face difficulties in finding work. This is more a result of the growth model rather than the growth rate. The current economic model is based on commodity industries and construction. The demand for white-collar workers is low. To improve the job prospect for college graduates, the economy must rebalance towards household consumption and private enterprises.

Containing the Damage

Deleveraging will cause losses in the financial market. It will not derail the economy or hurt most people. The decline in property prices will hurt a small portion of the population who hold tens of millions of empty flats. Most people will be happy to see properties more affordable. Some trust products will go belly up. The losses will be limited to a small group of people. Further, the losses would be mostly the profits from the high interest income in the past. Most people are not rich enough to have such products. The troubles in the trust industry will not affect social stability.

The decline in the stock market affects more people. But, the decline should be limited as the market has been low for a long time. Further, people have not made money in the stock market for two decades. A liquidity-inspired market surge does not last. The key problem is poor corporate governance. Until Chinese listed companies want to make money for shareholders instead of from them, the market will never make people rich. Deflating the financial bubble should make the market healthier by weeding out non-performing companies and rewarding the good ones.

Time Heals

The short-term panic will ease with time. When financial institutions see that speculation is not profitable anyone, they will decrease leverage and shift funds to the real economy. It will help the real economy over time, possibly in six months. The solution to the liquidity crunch is to unwind speculative wealth management products, not more liquidity from the central bank.

The State Council says that the financial system should use monetary growth efficiently and reallocate the stock to more efficient activities. This is exactly what the country needs. What is needed is to maintain a stable monetary policy despite some panic in the short-term liquidity market. Not giving in to the short-term pressure is the key to a healthy financial system and the economy.

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