8/2/2019 When will Chinas bubble burst Andy Xie Former Chief Asia Economist Morgan Stanley

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When will Chinas bubble burst? Andy Xie Former Chief Asia EconomistMorgan

Stanleyexcerpted fromMy 1510.cn

Chinese stock and property markets have bubbled up again. It was fueled by bank lending

and inflation fear. I think that Chinese stocks and properties are 50-100% overvalued. The odds

are that both will adjust in the fourth quarter. However, both might flare up again sometime nextyear. Fluctuating within a long bubble could be the dominant trend for the foreseeable future.

The bursting will happen when the US dollar becomes strong again. The catalyst could be

serious inflation that forces the Fed to raise interest rate.

Chinese asset markets have become a giant Ponzi scheme. The prices are supported by

appreciation expectation. As more people and liquidity are sucked in, the resulting surging pricesvalidate the expectation, which prompts more people to join the party. This sort of bubble ends

when there isnt enough liquidity to feed the beast.

Liquidity isnt a constraint yet. Even though loans grew by 24.4% in the first half or Rmb

7.4 trillion, loan-deposit ratio increased only to 66.6% in June 2009 from 65% in December

2008. It means that many loans have not been spent in real economic activities and have merelysupplied leverage for asset market transactions. Chinas property market is very similar to Hong

Kongs in 1997.

The origin of the asset bubble in China is excess liquidity as reflected in high level of

foreign exchange reserves and low loan deposit ratio. The low interbank rate defines how serious

excess liquidity s. The massive buildup of liquidity in China was due to weak dollar and strong

exports. As dollar entered a bear market in 2002, Chinas Rmb followed it down. Theappreciation expectation drove liquidity to China. One fourth of Chinas foreign exchange

reserves could be due to this factor.

Chinas productivity rose rapidly after it joined the WTO. The massive buildup ininfrastructure and the relocation of manufacturing sector to China pushed up Chinese laborsproductivity rapidly. At the same time, Chinese currency declined as it rose against the dollar

less than its decline. The combination of rising productivity and weak currency led to the

massive export growth. The resulting dollar earnings pumped up Chinas monetary system.

While China is experiencing weak exports now, the weak dollar allows China to release the

liquidity saved up during the boom in the past five year without worrying about currency

depreciation. How far would the bubble go and for how long?

It is not too hard to understand when the bubble would burst. When the dollar becomesstrong again, liquidity could leave China sufficiently to pop the bubble. Whats occurring inChina now is no different from what happened in other emerging markets before. Weak dollar

always led to bubbles in emerging economies that were hot at the time. When the dollar turns

around, the bubbles inevitably burst.

It is difficult to tell when the dollar will turn around. The dollar went into a bear market in1985 after the Plaza Accord and bottomed ten years later in 1995. It then went into a bull market

8/2/2019 When will Chinas bubble burst Andy Xie Former Chief Asia Economist Morgan Stanley

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for seven years. The current dollar bear market began in 2002. The dollar index (DXY) has lost

about 35% value since. If the last bear market is of useful guidance, the current one could lastuntil 2012. But, there is no guarantee. The IT revolution began the last dollar bull market. The

odds are that another technological revolution is needed for the dollar to enter a sustainable bull

market.

However, monetary policy could start a short but powerful bull market for the dollar. In the

early 1980s Paul Volker, the Fed Chairman then, increased interest rate to double digit rate tocontain inflation. The dollar rallied very hard afterwards. Latin American crisis had a lot to do

with that.

The current situation resembles then. Like in the 1970s the Fed is denying the inflation risk

due to its loose monetary policy. The longer the Fed waits, the higher the inflation will peak.

When inflation starts to accelerate, it would cause panic in financial markets. To calm themarkets, the Fed has to tighten aggressively, probably excessively, which would lead to a

massive dollar rally. This would be the worst possible situation: a strong dollar and a weak USeconomy. Chinas asset markets and the economy would almost surely go into a hard landing.

How far the bubble would go depends on the governments liquidity policy. The current

bubble wave is very much driven by the government encouraging banks to lend and the super

low interbank interest rate. As the Feds interest rate is zero, the dollar is weak, Chinas foreignexchange reserves are high, and the loan deposit ratio is low, China could increase liquidity,

which would expand the bubble further. However, other considerations may motivate the

government to cool it off.

Just to be clear: the economic situation remains terrible, indeed worse than almostanyone thought possible not long ago. The nation has lost 6.7 million jobs since the

recession began. Once you take into account the need to find employment for agrowingworking-age population, were probably around nine million jobs short of where we shouldbe.