CHINA : BEIJING BUBBLENOMICS / THE WALL STREET JOURNAL OP EDITORIAL ( VERY HIGHLY RECOMMENDED READING )

OPINION

AUGUST 14, 2009.

Beijing Bubblenomics

By MICHAEL KURTZ

Chinese policy makers fearful of bubbles have lately spooked markets into thinking they might soon take away the monetary punch bowl that's been fueling the local asset recovery. Don't be fooled. Beijing is likely to continue priming the monetary pump to support domestic markets. Leaders likely see few other realistic options right now, and a looming political transition in 2012 may create disincentives for the kind of structural reforms that higher-quality Chinese growth needs.

Fears of a premature Chinese monetary tightening have also been stoked by recent improvements in the American economy, where both the housing and job markets are showing faint signs of life. A China where exports are humming again would not need to rely so much on its own housing market for growth, and thus could afford to reel in liquidity faster. Seemingly in line with this assumption, monthly lending data released this week show that new lending in July dropped to $52 billion from a monthly average of $180 billion in the first half of 2009.

Yet this "tightening" is not all it seems. Exports remain weak despite positive signs from the U.S. and Europe, and domestic consumption has a long way to go to make up the gap. Spending on infrastructure is contributing massively to 2009 growth. Due to the strength of this year's fiscal stimulus, though, such outlays will be hard-pressed to carry GDP forward in 2010. New Chinese corporate investment is less dependable amid reduced external demand and dampened profits.

Thus residential housing construction stands as Chinese leaders' best hope for immediate results. To induce property developers to start new projects, policy makers first had to encourage a rapid drawdown of China's existing unsold housing stock by bolstering shattered sentiment with easy money. This has worked; unsold housing is now equal to roughly nine months of demand, down from more than 14 months at the start of the year. Spurring the property market to this degree is arguably China's most impressive economic feat of 2009, but Beijing needs to sustain confidence indefinitely for developers' crucial supply response to kick in.

Seen in this light, stable or rising prices on assets like property, far from being an accidental consequence of loose monetary policy, stand out as the purpose of that policy. The fact that housing construction must carry so much of the growth burden means policy makers likely prefer to err well on the side of too much inflation, rather than risk choking off growth too early by mistiming tightening.

Meanwhile, China's political cycle may exacerbate risks of an asset bubble. President and Communist Party Chairman Hu Jintao and other senior leaders are expected to step down at the Party's five-year congress in October 2012. Much of the jockeying for appointments to top jobs is already under way, especially for key slots in the Politburo. Mr. Hu will want to secure seats for five of his allies on that body's nine-member standing committee, ensuring his continued influence from the sidelines and allowing him to protect his political legacy.

This requires that Mr. Hu deliver headline GDP growth at or above the 8% level that China's conventional wisdom associates with robust job creation, lest he leave himself open to criticism from ambitious rivals. The related political need to avoid ruffling too many feathers in China's establishment also may incline leaders toward lower-conflict approaches to growth rather than deep structural reforms that would help rebalance demand toward more sustainable private consumption. Easy money is less politically costly than rural land reform or state-enterprise dividend restructuring. This is especially the case given that much of the hangover of a Chinese asset bubble would fall not on the current leadership, but on the next.

Meanwhile, a "bubble coalition" may be building at the economy's ground level. China's banks were initially reluctant to jeopardize their hard-fought internal reforms in the name of inflating a monetary bubble through increased lending. But now that they have lent out massive new sums to homebuyers, developers and governments that reap revenues from land sales to developers, the banks have a bigger stake in keeping property prices firm. Homeowners are part of this coalition too, especially the substantial number who are circumventing official downpayment requirements and buying houses with 100% debt.

For all these reasons, China's leaders most likely want to stage-manage asset inflation instead of stopping it. Despite all the talk from Beijing about curtailing excessive credit expansion, policy makers have not taken truly decisive steps, such as raising reserve requirements on banks to sop up liquidity. Even July's bank lending slowdown is less than it appears, given rising offsets from household-savings outflows and a ballooning influx of cross-border hot money.

Rather, officials seem concerned mainly with injecting occasional reminders that markets are still two-directional, so as to avoid a one-way stampede with more dire inflationary consequences. When their negative rhetoric is too effective, they've proven just as willing to talk markets up again. On recent occasions when the Shanghai composite stock exchange has racked up big one-day losses or property sales have softened, either the central bank chairman or Premier Wen Jiabao has quickly reassured markets that strict tightening is not imminent.

All this is at least leading to some accidental reforms as policy makers try to vent monetary pressures. Domestic initial public offering issuance has been restarted, with five companies listing shares worth a total of $7.9 billion just since July 10. The main intent is to absorb errant liquidity, but such listings might also help usher in governance reform via further privatization. China also is increasingly green-lighting capital outflows, such as outbound mergers and acquisitions and portfolio investment through sovereign entities. A freer capital account is a positive and necessary step on China's long-term path toward economic modernization. Still, a recovery strategy dependent on reinflating an asset bubble is fraught with risks. It could exacerbate politically destabilizing wealth disparities, cause misallocation of savings and physical resources, and create the threat of widespread wealth destruction if policy makers misjudge the exit strategy and have to step hard on the brakes. Inflationary missteps also could spur a return to price controls, as seen in January 2008 when China last fought back inflation. This would reverse admirable recent price liberalization designed to encourage more efficient resource use.

There's a saying that you meet your fate on the road you took to avoid it. If China continues down the road of asset inflation to drive growth, rather than embracing tough structural reforms, that fate may be more troublesome than policy makers expect.

Mr. Kurtz is Shanghai-based China strategist and head of China research for Macquarie Securities.


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