By Chan Akya
May 25, 2007
SourceTwo weeks back, I wrote about changes in China's foreign-currency regime, [1] which could set off a worldwide panic. The implicit assumption in that article, that Chinese policymakers would act rationally, must, however, be tempered in the context of the most recent actions.
Much like the embedded irony of George W Bush waging war for peace, in China's quest to become a responsible citizen of the world, it appears that it is becoming the exact opposite, at least in financial matters. The result will be both contagious and catastrophic as all central banks battle their increasing impotence by acting in concert, in turn setting off a worldwide correction in stock markets, and possibly a deep recession.
Even as China's central bank has acknowledged in recent weeks an increased desire to widen the trading band of its currency, the yuan, it hasn't achieved much appreciation in practice against the US dollar. After all, multiplying the daily trading band by the number of days it has been operational shows that the yuan should have already doubled in value, but has only instead eked out a single-percentage-point increase. That, more than any statement, shows that the People's Bank of China (PBoC) has been actively buying up the US dollar over the past few months, belying any notion of an actual trading band.
The dollars thus bought have been parked in low-yielding securities, including short-maturity US Treasuries and other high-quality debt issued by various agencies. A contrasting investment in China's own stock or property markets would of course have rendered significant returns, not that any central bank would contemplate such strategies. Instead, and quite belatedly, China has begun to take steps that I outlined in a previous article [2] to expand the return on its investment pools.
This doesn't mean China has kept quiet on soft measures to tame its domestic stock and property markets. It appears to have employed the services of Hong Kong's renowned tycoons in spreading the bubble-logic around China. Two of the richest men in Hong Kong - Li Ka-shing, chairman of Hutchison Whampoa Ltd, and HSBC executive director Peter Wong - have recently spoken about the stock-market bubble, describing it as a big problem for Chinese. They have limited impact on the actual trading traditions in Shanghai or Shenzhen, but will be seen to have done their part helping the central government in its quest to tame the markets.
And this week former US Federal Reserve chairman Alan Greenspan warned that the Chinese stock market was heading for a "dramatic contraction" and that the equity bull run could not last. The market fell moderately in early trading on Thursday as a result.
Trojan horsesIt is often too easy to get over-excited about things going on in the financial market. Last week's subscription of US$3 billion by China's investment vehicle in the private-equity company Blackstone set off headline writers around the world, all wishing to examine the sinister implications of such a move.
While some argued that China would use its investment to spread financial tentacles around the world, others argued that the US government was doing the opposite to China by making it throw good money at speculative investments. Given my past comments on the mismanagement of reserves by Asian central banks, which has resulted in billions of dollars' worth of lost income, the recent move by China should indeed be applauded. However, what really matters is how and when China will choose to expand its returns further in coming months and years.
While I admit that pretty much anything is possible these day, particularly in games with stakes set as high as US-China relations, it is more likely that such commentators are making too much out of this deal. The amount invested does look like a nice chunk of money, until one realizes that it represents less than 0.25% of China's foreign-exchange reserves - in other words, less than the interest payments that China receives on its bond holdings every month.
This leaves us with an alternative interpretation of China's motives, namely that it is "paying to play", ie, investing a small amount of money to understand the investment strategies employed, pitfalls and costs. With a sufficiently broad understanding, China could then expand its investments in such directions as it sees fit. Indeed, experience suggests that China does employ such strategies, by first investing money with professional asset managers in a particular asset class, and then expanding its own investments in that asset class over a period of time by first duplicating the asset manager's strategy and then fine-tuning gradually.
Sleight of handLike a pair of talented magicians whose elaborate theatrics and extravagant hand gestures or facetious speeches serve mainly to distract the audience from observing cunning sleights of hand, China and the United States are engaging in various actions that lull observers into a false sense of comfort. To wit, the question is not what China and the US are doing, but rather what are they trying to achieve for their respective economies.
America's war economy needs to maintain bubble-like conditions in the housing market to avoid a recession, while China needs continued growth in its exports to fund the excesses being perpetrated in the stock and property markets. While the central banks of both countries are queasy about the prospects, their masters in government are most certainly not.
However, the Chinese government may have underestimated the likely motivations behind the actions of the US Congress in coming months, and especially the shrill rhetoric ahead of next year's presidential election. On the former, it is possible that wider-ranging duties are proposed by Congress on Chinese goods to serve as a warning of further trade restrictions.
Meanwhile, both governments have also underestimated the impact of the housing and stock-market bubble in China on policy constraints. As I wrote in the previous article on abrupt policy changes, China has for all intents and purposes lost control of these markets, and must now worry about a mounting bill for rescuing investors who have bet their life savings on one, or more likely both, of these markets. The social problems caused in Hong Kong during the deflationary years are still too fresh in Beijing for the risk to be considered. In contrast, sacrificing some export jobs by letting its currency appreciate seems like a bargain in terms of money being spent on workers' compensation and resettlement.
The central banks in both countries have lost their effectiveness. For example, if the Federal Reserve signals higher interest rates in the US, it will likely not have a big impact on bond yields, because of Chinese buying of US Treasuries. Similarly, any announcement by the PBoC on rate rises has fallen on deaf ears locally, as investors continue merrily to pile on the risks by using money that is recirculated from currency-market intervention. Thus in both cases it is China's currency regime that has helped to propel asset bubbles.
Within all the sound and fury around financial markets, circumspect readers should not lose sight of that fact.
Notes1. Brace for a China-led chill, Asia Times Online, May 12.
2. Sun-Tzu's art of investing, ATol, February 10.