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MARKETS INSIGHT   June 3, 2013 9:25 am

J

Markets Insight: Weaker yen could burst China’sasset bubblesBy Charles Dumas

Overvaluation of China’s real exchange rate has now reached an

estimated 33 per cent

apan’s policy trajectory threatens to burst China’s asset bubbles. Japan has devalued

the yen competitively: US and European real exchange rates are down some 10 per cent

since 2009, courtesy of quantitative easing and the euro crises. Surprise interest rate cuts

in a number of countries hint at dangerous imitation. China is the most exposed: following

Japan’s devaluation (echoed in Korea and elsewhere), China’s overvaluation has now 

reached an estimated 33 per cent.

 At just over Y100 to the dollar the yen is cheap enough to get Japan’s economy back to itstrend level from 2.5 per cent below it, with growth of 3 per cent this year and perhaps 1 per

cent in 2014, and to eliminate deflation. Sharp increases in import costs could raise CPI

inflation to 2 per cent (the new long-run target) by year-end or early 2014, but domestic

costs are now still falling. That may stop by the end of next year, but CPI inflation could

also fall back to zero unless there is a further yen devaluation, perhaps to Y120 versus the

dollar. Inflation of 2 per cent is unlikely to last with the measures adopted so far.

But there are large internal and external risks in further devaluation. If the authorities are

content to look at CPI inflation reaching 2 per cent by late this year, and declare the policy a success, they will have achieved a lot, maybe as much as can be hoped for without drastic

reforms of income distribution within Japan.

Further yen devaluation may just happen. Current zero interest rates may be unacceptable

to investors with the principal sum no longer boosted in real terms by deflation. This risk 

exists even with mere elimination of deflation at the current exchange rate – especially 

given likely near-term positive CPI inflation. But a further yen slide would make it much

more acute.

Last year’s Japanese budget deficit was 10 per cent of GDP and is being increased. The

gross public sector debt is 240 per cent of GDP, net debt 135 per cent. Without deflation,

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the return on that debt at interest rates of well under 1 per cent is inadequate, for all except

the Bank of Japan under QE. The long-feared inflationary downward spiral could ensue:

ever-greater money creation would be needed to mop up all the debt and hold down bond

 yields.

The biggest external risk concerns China. Its real exchange rate has become overvalued. It

is heavily exposed to developed world countries ratcheting down their real exchange rates.Since abandoning the fixed 8.28 yuan/dollar rate in 2005, China’s unit labour costs have

 been rising at 7 per cent a year, and its currency by 4 per cent, for a combined annual 11 per

cent in dollars.

Overvaluation became a serious problem in 2011. Producer price inflation (PPI) of 7 per

cent then matched unit labour costs (in yuan), but crumpled into 2-3 per cent producer

price deflation over the past couple of years. April’s 2.6 per cent deflation has intensified

from 1.6 per cent in February. Chinese businesses have to slash prices to keep a grip on

their export markets. But unit labour costs are still rising at a 5 per cent rate, squeezingprofit margins, and are up 20 per cent relative to the export competition since 2011.

 Adding to this problem is the sudden, related, swing into high real interest rates. In mid-

2011, the one-year lending rate from state-owned banks was 6.6 per cent, which combined

 with 7 per cent PPI to give a slightly negative real rate. But a flight of depositors from

China’s banks has kept nominal interest rates high. The nominal interest rate is only down

to 6 per cent now, but combined with PPI deflation, the real interest rate is close to 9 per

cent. Such high real interest rates combined with squeezed profit margins have pushed

China into a prolonged “investment-led” slowdown.

China’s extravagant post-crisis recovery splurge, with capital spending raised to 48 per

cent of GDP, much of it debt-financed, has left it with high prices for real estate and

industrial commodities. These assets with low-to-negative yield are also the most sensitive

to interest and exchange rate changes. Whether or not Chinese real estate is in a bubble,

high nominal and real interest rates make these asset prices vulnerable.

Premier Li Keqiang spoke recently of plans to remove controls on capital outflows. Any such action could release a wave of savings seeking real foreign assets. This would devalue

the yuan and cushion the rebalancing of the economy away from excessive capital spending.

But it would also drain away bank deposits, threatening a major domestic asset sell-off as

 well as bank insolvency.

China’s annual savings are $4.5tn, versus $2tn in the US; their flow is vital. Chinese assets

are thus under threat both under current policies or the chief liberalising alternative. The

stakes are high in a potential currency war.

Charles Dumas is chairman of Lombard Street Research

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