No Sugarcoating It: A Hard Landing Is Likely
Bubbles and Consequences
China's property bubble had a major adjustment in 2012. The economy, of course, was adjusting too, as sales of new properties had been close to 15 percent of GDP. Both were healthy developments. China had a labor shortage. An economic downturn could be absorbed easily. The difficult task was to handle the financial fallout. But, at least, the mess would not become bigger.
Speculation and the economy have returned this year, mainly due to the shift in the official rhetoric to put growth stabilization first. It felt like miracle: mere words could revive the second largest economy in the world. It worked essentially like an assurance to speculators that the government would hold the floor. As the economy has become so dependent on speculation, stabilizing growth is equivalent to supporting speculation, which speculators would interpret as printing more money. As discussed before, the money printing has become self-fulfilling, as the carry trade is a major financing source.
China's rhetoric on growth and the Fed's on unemployment have reinforced each other in expanding a gigantic global bubble, bigger than the one before 2007.
When the bubble bursts, the impact on China and the United States will be very different. The United States' bubble is mainly in the stock market and in the properties for rich people. Its debt is not rising rapidly. Hence, when the bubble bursts, it is merely a round trip for speculators. China's bubble is sustained by debt. Its destructive power is much greater.
China's bubble may engulf more and more middle income people. For example, Shanghai's small apartments in old buildings may have risen 20 percent in price this year, while the prices of the large and expensive ones have not moved significantly and are still lower than two years ago. The small flats are rising in price because the total value seems small, like between 1 million yuan and 2 million yuan, and, hence, are possible speculation targets for average middle class households. But, the unit price is quite close to that of expensive centrally located flats. It works like stock splits that suck low-income punters into low-quality stocks. China's property bubble is evolving like the stock market in 2007, passing losses to the masses while insiders walk away with the cash.
Reform Isn't Speculation
Financial markets initially interpreted the communiqué released after the third plenum of the Communist Party's 18th Central Committee as long on lofty rhetoric and short on action and, hence, sold off. The release of more details, like loosening the one-child policy and allowing offshore insurance in the Shanghai Free Trade Zone, triggered a bounce. Even these measures are minor. The market responded because it saw the government respond to the market decline and believed that more candy would come in case of further market declines, i.e., the government wanted to support a market floor.
Real reform is not candy for speculation. China's is a bubble economy. Any real reform would trigger severe pain in the financial system. No reform, on the other hand, delays the inevitable and makes the eventual pain more severe.
China's reform is about changing the role of government, not tinkering with the market system. The country's economic challenges are overinvestment and overcapacity; financial challenges are inflation, bubbles and shadow banking; social challenges are environmental degradation and unsafe foodstuff. All these problems are related. The government's desire to maximize investment, revenue and spending power drives the economy. This desire is like a sort of supergravity over the market. Market improvements will be squashed under this force.
For example, interest rate liberalization sounds good and is good. However, local governments and property speculators or developers are the main borrowers. The later always hands their borrowed money to local governments as taxes. Would interest rate liberalization divert funds to other more efficient uses? Absolutely not. Other industries are not doing well and could not compete to pay higher interest rates anyway. On the lenders' side, who would jack up rates to attract funds? High-risk takers like city banks that would probably feed the money to their governments.
The Story of Bottled Water
Bottled water has become ubiquitous across China. The reason is that tap water is unsafe to drink. That is due to environmental degradation. Why is water pollution so severe? Other industrialized countries have experienced far less pollution. China's severe pollution is mainly due to local government desire to attract investment. Ignoring the environment is an advantage in this game, as it cuts production costs. Because there is no other power to offset the government's influence, widespread and severe environmental degradation is inevitable. The bottled water business reflects this.
As demand for bottled water grows, of course, it is an investment opportunity, too. Hence, the safety of bottled water becomes an issue. If one is willing to sacrifice the environment to attract investment, why not lower the standards for bottled water? That is indeed a serious issue. Consumers have to guess which bottled water is safe.
A further story is how bottled water has become a source of revenue. As some suppliers have become successful in the market, governments find it more profitable to tax them. Hence, the price of bottled water is rising.
This water story illustrates how much China's economy is distorted by unhealthy government power. This business is so big because of a government failure. As consumers pay for bottled water, it has become a source of government revenue, which, of course, goes into more investment.
China's Consumer Price Index is rising rapidly, and the Producer Price Index is falling rapidly. Such a dichotomy could not happen in another economy. In China, the two work together. As production loses money, more subsidies are needed to keep it afloat. Hence, governments will find opportunities to tax distribution. Hence, more PPI deflation and more CPI inflation.
Of course, the property bubble is much bigger than the water story in monetary terms. Its raison d'être is the same: to satisfy the government. Like all other unusual economic phenomena in China, it is a reflection of the government's supergravity.
Real reform is about limiting government power. No other reform is meaningful in the current context. As reforming the government is likely a long and slow process, China's bubble economy will run its course, exhausting all the available money and all the potential entities for borrowing. A hard landing at the end seems quite likely.
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