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China Chasing Bubbles

International | Aug 31 2009

By Greg Peel

“It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose.”

So said Lou Jiwei, the chairman of China’s US$300bn sovereign wealth fund China Investment Corp, on Saturday. In 2009 the CIC has invested as much money each month as it did in all of 2008, Reuters reports.

The Global Financial Crisis came about following the bursting of what had been decades of a growing developed world debt bubble. In this decade China has grown from emerging market curiosity into a global economic powerhouse, at the same time creating its own bubble economy up to 2008 as it fed the developed world’s insatiable desire for goods bought on credit.

When the stark realities of the impending GFC were becoming apparent, and the collapse of Lehman Bros provided the final trigger, the developed world knew it was staring into the abyss of another Depression, possibly even more devastating than the Great one. Governments and central banks had to decide between two paths. Recognising that debt-based investment and consumption had become way out of hand, they could have taken the approach of allowing the unstable structure to collapse such that a new structure could be re-established off a fresh, firm base. This is what economists call “creative destruction”, and allows money to transfer “from weak hands to strong” such that the resultant global economy can be one of much greater inherent strength.

There were few who could argue that this would not be, in the long run, the most sensible thing to do. But the problem was such a solution would have meant the collapse of pretty much the entire world’s banking system, widespread unemployment, hardship, disenfranchisement and probably civil unrest at a time the world was also fighting a supposed War on Terror. Put simply, the demise of the “fat cats” would have been most keenly felt by the working class. And incumbent governments would surely lose their next elections.

So the other path was chosen. The chosen path was to stem the tide of massive private sector deleveraging by replacing it with public sector leverage. In the US, this meant propping up all the major banking institutions with government funds, all but nationalising the sponsored mortgage companies, and the largest bond insurer, and the largest auto manufacturer. It meant fixing the problems created by “cheap” money by offering more “cheap” money, and to further support stability by the monetization of government debt – the purchase of government debt by the central bank funded by government debt, otherwise known as quantitative easing.

The UK also monetized its debt, and partially nationalised a large segment of its banking system. Japan, Switzerland and Canada joined in. Across the globe governments guaranteed base level savings deposits, provided direct consumption inducements through cash hand-outs, home-buyer grants, “cash for clunkers” and other programs. And in order to create jobs, governments announced huge debt-funded infrastructure programs.

The idea was to prevent another Great Depression first, and then to later worry about (a) how to reel in the government debt which was replacing private sector debt without creating hyperinflation; and (b) what to do about ensuring another bubble-bust cycle of the nature of the GFC could not occur.

And it appears to have worked. To date it seems the US, UK and Europe have suffered a deep but not too destructive recession, while the likes of Australia appear not to have suffered a “recession” at all. Certainly not one as bad as 1992, at this stage.

Over in China, the concern leading up to 2008 was that a runaway economy might bust by itself. The Chinese government didn’t have to wait to find out nevertheless, because the GFC burst the bubble anyway. But China went into the GFC with a massive current account and fiscal surplus, whereas the US was carrying a massive deficit in both (now becoming more massive). Australia was carrying a large current account deficit but a large fiscal surplus, brought about by never spending any money. This has been a fortunate boon for Australia, although the money that could have been spent on hospitals, schools, public transport, ports and other infrastructure must now be spent via debt funding.

China began using its surplus in late 2008 to bounce itself out of the GFC doldrums by stimulating a still immature domestic economy. The result has been a bounce in global commodity prices and – arguably – a prop to the developed world in avoiding deep recession. But cheap money in China has also meant a stock and property market bubble.

Economists believe China will likely allow this bubble to keep expanding, perhaps only making minor adjustments to policy to try and keep a lid on runaway speculation. China wants to help stimulate the developed world back into being import economies, thus rekindling China’s export industry and setting the Chinese miracle back on the rails. Only when the developed world recovers from recession will it look to start reeling in easy policy.

Thus when the chairman of the CIC refers to China and America “addressing bubbles by creating more bubbles” he is citing cheap money on either side of the Pacific (funded by surplus in China’s case and deficit in America’s case) which is arguably only heading off one GFC by setting up for another one. All that will prevent another GFC might be several years of ongoing private sector deleveraging (preventing a hyperinflation break-out) and new financial market regulation and supervision that will supposedly ensure such creatures as the CDO and CDS, the NINJA mortgage and the exchange traded fund are not again allowed to run riot under the radar.

And thus a market has been created to be the plaything of the CIC. Indeed, the GFC has handed China the developed world on a platter. What might have seemed like a disaster in 2008 has become a fabulous opportunity for China in 2009 and beyond – the chance to quietly take over the world.

The CIC was created in September 2007 and the greenhorn fund did not see the subprime crisis writing on the wall. Two of its first big investments were in US investment bank Morgan Stanley and major US hedge fund Blackstone. At the time it appeared to China it was getting a bargain. By 2008 it was clear it was all a big mistake. But once the CIC figured out what was going on it learned from its initial impatience and retained 87.4% of its initial US$200bn in funds in cash and cash equivalent foreign instruments. That initial injection came from the Chinese government’s US$2.3 trillion of reserves. In 2008 when developed world investors were losing 50% of their money or simply going under, the CIC posted a return of negative 2.1%.

Not bad for beginners.

The CIC is now investing in a broad-based and diverse portfolio of assets across the globe. Despite US dollar risk from excessive debt the fund suggests it has no choice but to invest in the largest capital markets in the world. And as it holds its capital base in US dollars, there is in theory no risk on US investment were the US dollar to crash.

If 2009 returns prove positive and China’s foreign reserves keep building, the CIC will likely ask for further funding injections, Lou Jiwei announced. Diversification means the CIC is invested in products designed to generate both alpha (individual stock risk) and beta (market risk), hedge against both inflation and deflation, and to provide guaranteed returns should another GFC eventuate.

One presumes this is why Jiwei suggests the CIC “can’t lose”.

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