When the Giants Unwind
China and the United States, the primary sources of economic stimulus since 2008, will begin to unwind their stimulus in 2014. The Fed's announcement of its first reduction in quantitative easing and China's rising interbank interest rate are signals of what is to come. The main driver for the unwinding is concerns of bubbles, not that economies are strong enough.
Unwinding stimulus, especially one so large and prolonged, is fraught with unintended consequences. Bubbles tend to pop, not deflate slowly. Even though authorities are calibrating their tightening steps carefully to achieve a smooth landing, financial turmoil due to a bubble bursting is possible, which may drag the global economy into another recession.
Even if no financial turmoil emerges, some assets are likely to come under strong pressure. The economies that depend on commodity exports and/or hot money to plug their current accounts may see their currencies under more pressure. The Australian dollar and Brazilian real are highly vulnerable. The Indian rupee is another weak currency. The Canadian dollar and Russian ruble may come under pressure too.
Stimulus and Growth
After the 2008 financial crisis broke out, I predicted widespread monetary and fiscal stimulus all around, and such stimulus wouldn't bring back sustainable and sound growth, eventually leading to another crisis. I also predicted that stimulus advocates will blame the failure on insufficient stimulus. My predictions are coming true halfway there. Another financial crisis will make them whole.
The magnitude of the United States' stimulus could be measured by national debt rising from 62 percent to 100 percent of GDP and the Federal Reserve's balance sheet more than tripling from 2007 to 2013. The impact on asset prices is reflected by a 60 percent increase in household wealth from the crisis low and 21.4 percent above the 2007 peak – a level considered a bubble that led to the 2008 financial crisis. During the same period the U.S. economy has expanded by 6 percent in real terms and 15.8 percent in nominal terms. The current level of total employment is still below the pre-crisis level. It is obvious that the U.S. stimulus policy has had an outsized impact on asset prices and small one on the real economy or employment.
Why would the Fed decrease its QE while the economy is far from healthy? When the Fed first sounded its tightening warning in June, I argued that it was trying to manage an asset bubble. Before 2008, property appreciation was driving the U.S. bubble. Financial markets have been doing the job since. It appeared that the U.S. stock market was ready to spike like in early 2000 when the Fed sounded its warning. The market consolidated afterward. But, when the Fed backed off in September, it went on a tear again. When the Fed took its first step in December, it was viewed as too small to have an impact. The market has continued its rally. The S&P 500 rose by 30 percent in 2013. It remains to be seen if the Fed could prevent a rerun of 2000: the market surges in the first quarter of 2014 and falls sharply afterward.
China's stimulus, mainly through lowering the credit standard, led to a 175 percent increase in M2 from 2007 to 2013. The main growth consequences are a 61 percent increase in electricity production and an 82 percent increase in nominal dollar exports. While the growth data are still impressive, they are small in comparison to monetary growth. If such a relationship persists, hyperinflation is likely. Further, the growth numbers have come down in the past two years, while monetary growth has slowed less. The trend suggests that the effectiveness of monetary stimulus is declining. Hence, achieving the same growth target brings a higher inflation rate.
The growth dynamic in the past five years depends on local governments borrowing money to spend. The declining effectiveness of monetary growth reflects the same declining efficiency in local government expenditure. The growth dependency on local government spending is tied up with property speculation. As excessive monetary growth triggers inflation expectations, money has poured into land and property. As local governments control all the land supply, they have been able to raise revenues from selling land and borrowing money with land as collateral. These two are the main channels for money supply to turn into expenditure.
Neither China nor the United States has built a sustainable growth dynamic with stimulus. As the stimulus side effects – bubbles and rising leverage – become the main show unwinding stimulus becomes urgent. This is why both countries are likely to take tightening steps.
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