Why all the fuss about the dangers of a U.S. recession? Some academics point out that recessions are an important part of the business cycle because they help squeeze out economic excesses. When the Fed unexpectedly cut interest rates by 50bps in August, the organization made it clear that it was going to do everything in its power to prevent a recession. But doesn't this create a much wider form of moral hazard? If the Fed signals that it will always aim to prevent recessions, future investors may take on unnecessary risks and undermine the stability of markets. I'd argue that this moral hazard may already be embedded in China's notorious asset bubble.
Photo:Alexandra Moss, Creative Commons, Flickr
Wall Street will probably give Bernanke a standing ovation if he manages to prevent a recession, but such a scenario will make him (potential) public enemy number one in China. Everyone agrees that China's economy is a ticking time bomb, and by now the Chinese have demonstrated that they are not in control of their own fate. The future China's asset bubble is not in the hands of China's authorities, it is in the hands of China's export markets.
Evidence is mounting that China cannot use domestic policies to slow down demand, and the trend isn't expected to change in 2008. China has aggressively raised domestic interest rates and reserve ratios with little effect. A recent Morgan Stanley research note pointed out that:
[China's] investment cycle tends to reflect the macro policy stances, which are influenced heavily by the political cycle in China. Since the early 1990s, fixed-asset investment growth rates have reached a peak every five years, and the year of peak growth rate 'happened' to be the year of change of government. The next change of government is due to take place in March 2008. If this pattern persists (i.e. – investment cycle driven by political cycle), there appears to be a considerable risk of acceleration of investment growth next year, especially in view of the low interest rates, undervalued exchange rates and still-strong corporate earnings.
For more examples of China's inability to control their economy with domestic policies, be sure to read Martin Hutchinson's brilliant piece "The Coming China Crash" at the PrudentBear.com. Hutchison argues that the behavior of China Investment Corporation, the US$200 billion sovereign wealth fund set up by the Chinese government in September, shows why a China crash may be coming. A third of China Investment's portfolio is to be invested in Central Huijin Investment Company, a purchaser of bad loans from the Chinese banks. Hutchison demonstrates that the Chinese banking system's bad debt problem is in real terms about five times that of the United States, or about 40% of its GDP. He draws parallels between China's current situation and Japan's debt crisis in the early 90s that led to a period of little or no economic growth, lasting well over a decade.
If China was going to have an orderly slowdown it would have to come from a slowdown in external demand. And, assuming that China's asset bubble eventually pops, the sooner the better. A mild U.S. recession might be the perfect parachute for China's high flying dragon, as a significant moderation in export growth could lead to an imported soft landing. On the other hand, if Bernanke succeeds in avoiding a U.S. recession, demand for Chinese exports may pick up and China's time bomb will tick faster. Some suggest that a 50bps rate cut is on the cards at today's Fed meeting. In a classic example of yin and yang, such an event will be good news for Wall Street, and bad news for China.
Disclaimer: I have no exposure to Chinese markets, nor do I have any currency exposure.