There are those who take the view that the emerging Asian economies – especially that of China - might prove to be the salvation of Europe and America. This view rather neglects the unfortunate fact that the Asian economies – especially that of China – have problems of their own and it may not be entirely convenient for them to act as a rescuer to western economies. China, in particular, is suffering from an economy that is in danger of overheating. Inflation is rising and an awkward looking property bubble is forming on mainland China. Asking the government of China to add to that inflation seems to be unrealistic at best.
The size of trade deficits between China and both the Eurozone and the US has allowed the exchange rate to be used as a vehicle of monetary tightening. There has, in recent months, been a slow appreciation of the Chinese currency against the US Dollar and, to a lesser extent, the Euro. The main motive for this appreciation has been to act as a check upon domestic inflation within China rather than to act as a device to stimulate demand for American and European goods. However, the degree of appreciation has been nowhere near the levels needed to provide a stimulus for the sluggish Western economies. The Chinese government continues to manage the exchange rate in a way that minimises the possibility of internal unrest, which means that all changes are slow and deliberate. This is not set to change.
Monetary conditions within China now require a tightening. However, this policy also requires a great degree of finesse. The exact quantity of non-performing loans in the Chinese monetary system is unknown, but is thought to be much higher than in Europe, the US, and even Japan. Some estimates suggest that the degree of non-performing loans could be as high as a third of the assets on the balance sheets of Chinese banks. If the monetary authorities tighten too hard, this could expose the volume of these non-performing loans at exactly the wrong time, triggering a Chinese banking crisis. If the monetary authorities are lax in their tightening, then they might not deal effectively with the inflation that is weakening the Chinese banking system to begin with. In either case, a wobble in the Chinese banking system would have major global consequences.
It is worth considering how and why such a wobble might take place. In recent years, Chinese local authorities have been forming large numbers of joint ventures with the private sector bodies. A principal objective of the joint ventures has been to buy and develop property, especially throughout the eastern seaboard of China. The joint ventures have received preferential access to banking funds – often controlled or heavily influenced by the local authorities – to finance the investments. The allocation of capital has not always been on the strictest of commercial considerations. Not all of the loans made are fully performing. It would appear that, over this summer, the number of defaults in the Chinese banking system have started to rise.
We can expect this process to continue. As the Yuan continues to appreciate, as interest rates continue to rise, and as banking reserve ratios continue to creep up, the availability of new finance in China will diminish. This will have the effect of reducing demand in the property sector, which will lead to property prices softening. If panic sets in, as happened in 2009, prices could fall quite sharply to expose the weakness of many property funding arrangements. In itself, this will not readily transmit into the monetary system. One possible response by the Chinese central bank could be to ease credit in the face of a property bust. However, a consequence of that policy would be to rekindle the inflationary forces that are currently being dampened down. If, as is more likely, the monetary tightening were to continue, even in the face of a weakening property sector, the problem could easily transmit from the property sector into the financial sector.
If the property sector were to crash, it is likely that many property investors would also liquidate their stock holdings to cover their property losses, as far as they could. We could almost say that this is happening already. Since 2009, the Chinese economy has grown by over 9% per annum, whilst the stock exchange is trading at broadly comparable levels in nominal terms. If we factor inflation into the picture, then it is true to say that the stock exchange has witnessed negative real growth between 2009 and 2011. This partly reflects the flight of capital from China to the relative safe haven of the US (the Dow Jones Index is up by 20% over the same period, even allowing for a bad summer in 2011), but it also reflects the liquidation of stock holdings to cover losses in the property market.
At present, the effects of all of this have been fairly mild. There is a reasonable risk that such an event could become substantial. In April 2011, Fitch warned that it was changing its stance on Chinese local currency denominated debt from ‘Stable’ to ‘Negative’. The debt currently has an AA- rating, but could well be downgraded in the near future. If it were to happen, then the repercussions would be felt well beyond China. A run on the Chinese banking system could be accommodated by the Bank of China, but not without recourse to the repatriation of holdings of overseas debt that it owns. It is not unreasonable to conceive of a run on Chinese banks leading to a run on the American banking system in fairly short order. Beyond that, the contagion would spread to the global banking system quite rapidly.
At the moment, few observers have factored into their calculations the possibility of a renewed financial crisis originating in Asia. We feel that they ought to. There is a reasonable chance of financial instability emanating from the region, and we feel that the current view that Asia will rescue the European and North American economies is nothing more than fanciful.