The Japan-China Parallel: Is the Hot Money Already Running from China?

“If you do not change direction, you may end up where you are heading.” — Lao Tzu

Most everyone thinks they know where China is headed — that is, toward world domination thanks to having the most-vibrant large economy in the world.

Of course, whenever we project from the recent past, we usually end up disappointed. And for many, their expectations for China will be no exception.

There are many obstacles along the way before China rules the economic world, and one of them is what we have dubbed “The Japanese Parallel.” This would be a game-changer, one with major implications for all global asset markets, especially currencies.

The credit crunch that happened circa 2008 took a big bite out of the U.S. consumer and has drained a lot of dollar credit out of the global system. In the aftermath, the Chinese government stepped up in a big way — replacing U.S. consumer demand with direct stimulus, to the tune of approximately half the size of the country’s GDP, in an effort to keep the music playing.

The song should be a familiar one because, interestingly, we saw a similar scenario play out before in the global economy. China’s future is on a seemingly eerie parallel with Japan’s global macroeconomic history.

The Parallel in Play

During the 1980s, it appeared Japan — as the “Creditor Superpower” — was going to gobble up the world with its powerful export machine and massive current account surpluses rolling in.

Then a little thing called the U.S. stock market crash in 1987 changed the game.

Dollar credit flowed from the global system, triggering an improvement in the U.S. current account balance (see the top-left gold box in the chart below) that was followed by a U.S. recession. This came as the Japanese yen was appreciating in value, thanks to the G-7 Plaza Accord to pressure the yen higher because of all those Japanese exports.

Source: Black Swan Capital

Here’s a brief history on what happened to Japan:

1. Japan’s very hot stock market broke in 1989.
2. Then its extremely overpriced real-estate bubble started its collapse. (Remember when the Imperial Palace in Tokyo was worth more than the entire state of California?)
3. Japanese authorities did all they could in the form of stimulus to try to keep air in the bubble. They …
1. Pumped more money into the stock and property markets in order to revive the wealth effect for domestic consumers.
2. Subsidized export companies to keep exports flowing (but the world’s major consumer — the U.S. economy — was entering recession and therefore wasn’t there to buy).
3. Lowered interest rates to zero.
4. Continued massive fiscal stimulus by building infrastructure across the country.

But, it didn’t work.

The massive dislocations were caused by the artificial channeling of credit within the Japanese economy in order to focus almost entirely on building a global export machine.

In turn, these dislocations created the malinvestment that has taken years to work off, precisely because the Japanese economy was so imbalanced when it came to production versus consumption.

Attempts to change this model were scant at best; instead, they kept morbid companies alive and forced consumers to save money, thanks to artificially low interest rates.

7 Reasons Why the China Story
Might Not Have a Happy Ending

Fast-forward to China today … and you can witness the parallels …

Instead of the U.S. stock market crash being the triggering event, we have the credit crunch in its place — arguably a much-bigger and more-powerful global event.

Secondly, global leverage — i.e., debt in the system — was massively larger in 2007 than it was in 1987. (In other words, the world was hooked on massive dollar-based credit spewed out by the trillions of dollars in derivatives production.)

Mr. U.S. consumer has pulled in his horns much more quickly and to a greater degree than he did back in 1987. This takes much more global demand for goods out of the market — demand that China was and still is so highly addicted to.

And interestingly, now we also have the Chinese currency starting to rise in value, albeit at a much-slower pace than the Japanese yen did in the 1980s.

So what has China done to overcome this sea change in the global economy that’s evidenced by the improvement in the U.S. current account? The country has done many of the same things Japan has done, and we are seeing a replay of events to a degree.

Here’s where those parallels really come into play:

1) China’s very hot stock market topped out in October 2007 and is now 59 percent off its old high. (That is a major drag on the so-called “wealth effect.”) The Chinese government owns or controls most of the stocks on its exchange and, yet, it has been unable to keep them pumped up.

2) China’s real estate prices have started falling and the “bubbly conditions” are becoming quite apparent to all. But now, with tightening credit in China, the bubble is in jeopardy. As a recent Financial Times article reported:

“The number of property transactions in China’s largest cities has fallen to dangerously low levels, according to regulatory documents obtained by the Financial Times.

“According to the documents, the China Banking Regulatory Commission earlier this year ordered domestic banks to weigh the impact of a 30% decline in housing transactions in ‘stress tests’ aimed at determining the health of the Chinese financial system.”

3) China’s real estate market, especially on the commercial side, is extremely overbuilt. A massive amount of speculative credit has poured in that could come rushing out; already there are signs that the hot money is running from China.

Interesting point here: Despite Western pressure on China’s currency policy, country leaders have made it clear there will not be any type of one-time ramp-up revaluations; this adds to the momentum of hot money (that had poured into China) to leave.

Part of that hot money was specifically positioned in real assets to benefit from such a large one-off revaluation.

4) The country pumped more money into the stock and property markets in order to revive the wealth effect for domestic consumers. It hasn’t worked, just as it didn’t in Japan.

And just as Japan found out, there is no fallback to local demand if international demand disappears for their exports. This is already in play.

5) They subsidized export companies to keep exports flowing. (But the world’s major consumer is taking the goods to the degree that it did before the credit crunch.)

China has managed to push some of the pain of domestic adjustment off its trade partners thus far. But if the U.S. consumer does not materialize, trade frictions will grow for China — not just in the West, but also from its Asian-bloc competitors. This is already in play as well.

6) China’s interest rates are not at zero, but they are extremely low for a country supposedly growing as fast as it has. This low interest rate policy is similar to what Japan did. This leads to forced savings and smothers local consumer demand at a time when domestic consumption is most needed.

7) They continued massive fiscal stimulus by building infrastructure across the country. China’s infrastructure development is legendary. It has led to extreme overcapacity across many sectors.

If global demand is not there to take the final goods all this capacity can produce, then much of that capital will be wasted (i.e., malinvestment). This is what happens when a government determines investment policy instead of letting the market do its job.

Officially, China sports quite a low debt-to-GDP ratio. But if you consider that Chinese banks are effectively government conduits, some have estimated debt-to-GDP in China is somewhere between 70 percent and 80 percent.

Could China Get Hit
Harder Than Japan?

The credit crunch is the market’s way of starting to rebalance a very imbalanced global world that has at the heart of it:

• A flawed world reserve currency system;
• Inordinate demand and depth of capital markets concentrated in one place (i.e., the United States); and
• A beggar-thy-neighbor — by which the country attempts to help itself by using measures that negatively impact other countries — export policy (Asia), leading to massively suppressed relative currency values.

This potential global macro replay shows that policymakers have either learned little, or are unwilling to do the heavy lifting, when it comes to real global monetary reform.

If the Chinese economy plays out like Japan’s did when its credit bubble burst, the implications for the global economy would be dire, as we are still in the midst of massive private deleveraging. This is already overwhelming the public debt being poured into the system, and it has created the nasty byproduct of shaky sovereign credits across all Western nations.

So, we continue to watch as China ticks off the historical markets that crushed Japan’s growth and economic leadership. And we hope that the part about history repeating in another form is wrong. Otherwise, it could be even uglier this time around.

Best wishes,

Jack

P.S. As I mentioned, the Japan-China connection could be a global game-changer, especially for currencies. In my World Currency Trader service, you’ll get timely trading information plus longer-term strategies to keep you one step ahead of the markets.