Dude, Where's My Bubble?

The 1999-2003 boom-bust in stocks and the more recent "event" in real estate has left most people thinking that markets always form and pop bubbles. "Where's the next bubble going to be?", is a common question these days, even by major-bracket investment house analysts. As I noted in a previous post, one of them even used the absence of a retail investor-driven bubble in US shares as a contrarian reason to recommend their purchase. Odd as it may seem, people seem to be hooked on bubbles.

Certainly, it's a big world out there and if you look at each market separately, across all asset classes and regions, then yes, there are bubbles and bubblettes forming and popping all the time. Last year the bubble in copper prices sadly caused people to be electrocuted when they attempted to steal high voltage transmission lines. A few months ago there was a bubble in the construction of corn ethanol distillation plants, which drove the price of corn higher. Severe droughts have caused a bubble in wheat prices. And there is a bubble forming in marine transportation shares, chiefly in bulk carrier companies.

But the biggest current bubble of them all is undoubtedly China - world class, global scale. I am not going to repeat what is going on there - we all know. I will isolate only two aspects:

a) The bubble in Chinese share prices is caused primarily by local ignorance of the very basics of investing and market economics. "China is in dire need of financial expertise", says Alan Greenspan in his new book and he adds, "...Chinese banks lack the professional expertise to judge what enables a loan to be repaid...To the extent that there are a lot of bum investments, part of the measured GDP is waste and of no value". These are very strong and direct warnings from a man who is otherwise famous for Delphic inscrutability and constant hedging of all pronouncements. (The Age of Turbulence, p. 307-308).

The fuel for this ignorance-driven bubble comes from the huge pool of hitherto stagnant bank deposits, formed after years of very high saving rates (40%+). After earning low rates of interest for years, they have now been unleashed unto the stock market. Well, as the saying goes, a few will make tons of money and the rest will, sadly, acquire "experience".

b) The PBoC is in a bind. After years of explosive monetary growth (20%+) which fortunately did not result in much inflation, China is finally and suddenly faced with two kinds of inflation at the same time: rapidly escalating consumer prices - chiefly for food - plus asset inflation in shares and urban real estate. They must have known it was coming (they have been raising interest rates and reserve ratios for months), but a pegged exchange rate removes the bite from their monetary policy bark. If China does not abolish the peg to fight inflation, it will eventually have to raise interest rates so much that will create very predictable negative effects for borrowers and banks.

In addition, if inflation is not combated right now, it will become embedded in peoples' expectations and result in constantly higher wage demands (structural inflation) - a clear problem for an export economy heavily reliant on labor cost arbitrage. With the "coming-out" Olympics due in 10 months, the political establishment may soon face a stark choice: a restless urban population squeezed by inflation vs. lower profits for business. If it comes to that, higher wages will win by a landslide - this is a country where communist roots are still very visible: Mao's portrait is on almost every banknote.

The Chinese government must allow the yuan to float freely, right away. China's is no longer a small, vulnerable and isolated economy; it is a major factor in the global economy and needs to adjust its currency accordingly. If it does not, it may soon find that politicians from the US and the EU will succumb to rising popular cries for the imposition of punishing import duties. The election cycle is a burdensome mistress, particularly if the domestic economy (eg in the US) is rapidly slowing down and scapegoats are needed.

Which takes us back to the "bubble" theme. So far China's authorities have not been effective in popping its asset bubble through half measures. I fully expect the next step is going to come soon and it WILL be effective.

So... there's your bubble. Don't go anywhere near it, unless you are the one carrying a big pin.