Déjà vu?28 June, 2011, 4:39. Posted by Zarathustra
Tags: Economy, Hong Kong, Real Estate, United Kingdom, United States, World
In this pretty disorganised note, which I originally wrote to a friend of mine on my view on global economy and real estate, I discussed some issues that long-term readers here would recognise that I have written somewhere else.
In the early 20th century, it was Argentina, which was thought to be the next great power after the British Empire. This is manifested by the fact that there was once a Harrods in Buenos Aires, the only one outside of the UK (i.e. the Knightsbridge one), which tells you how rich the country used to be. Then, we all know that it was the United States, not Argentina, which became the world next great power after the British Empire declined.
In the late 19th century or early 20th century, the United States had no interest in military power whatsoever. Its navy was ranked even after China back then, and they did not have a proper army to speak of when the British Empire tricked the United States into the First World War. The United States became one of the pre-eminent world powers after two world wars as it bankrupted the British Empire.
Throughout the Cold War, contrary to popular belief today that the Soviet was bound to lose, the United States showed every sign of losing it early on. This is illustrated by the so-called Sputnik moment. Indeed, the Soviet Union had spectacular economic growth, which left Americans wonder if command economy was a good thing. Of course, we know how the story ended.
Then there came Japan. If we draw a straight line from 1989 using the pre-crash economic growth rate, we would most probably have a Japan as the largest economy now. The United States was worried once again about Japan overtaking its own economy, with some popular books published in the 1980s explaining how the United States should be learning from Japan. Now, it looks like a joke.
Now, it is China. Just like President Obama has put it, it is our generation’s Sputnik moment. Particularly after the financial crisis, it seems that there is a popular belief that China’s economic model is somehow superior to the Anglo-American model of free market capitalism.
These historical precedents make me reject the absolute certainty that China coming out on top of everyone else:perhaps it will, or perhaps it won’t. In fact, my conjecture is that Anglo-American free market capitalism and parliamentary democracy will prevail at last, not the Chinese model, which, in the words of Professor Yasheng Huang, is becoming more or less like the old Brazilian model (which failed). If you are looking for the next great power who is a great follower of the free capitalism doctrine, it is India, which has a parliamentary democracy and an Oxford educated economist as their Prime Minister, not China.
2. Great Depression
Perhaps the most worrisome part is the comparison between today’s China and the pre-1929 Great Depression of the United States.
Post WWI, European Countries including Britain, facing the problem of inflation, decided to peg their currencies back to gold standard. In particular, the UK tried to re-peg the British Pound back to the pre-war gold standard in 1925, which hugely overvalued the British pound. The result is a relative undervaluation of the US dollar. Because of the undervaluation of US dollar, the US ran a trade surplus with the Europe, and at the same time the US is the creditor of the Europe, in particular, the Great Britain, after the British Empire effectively bankrupted itself with the Great War. Under the old gold standard, trade surplus entails inflow of gold into the US, and that gold are ready for creation of new money. As a result, we had the boom and bust in the stock market, and indeed every asset market. The inflexibility of gold standard exacerbate the problem after the crash.
Then, we look at Japan. Before the Plaza Accord, Japan pegged its currency with the US dollar. After the Plaza Accord, the appreciation of Japanese Yen produced a mild slowdown, so the Bank of Japan intervened the market by creating new money in order to keep the Yen undervalued, flooding the system with liquidity, and fuelling the real estate and stock market bubbles, which ended on the last trading day of 1989. Also, Japan consistently ran trade surplus with other countries.
Unfortunately, I have to say that China is, in these respects, same as the pre-Great depression US and pre-1990 Japan. It has an undervalued currency, and it ran trade surplus with other countries. That makes independent monetary policy hard, if not impossible. The inflow of gold (in the case of the US) or the accumulation of foreign exchange reserve (in the case of Japan and China) means that in order to maintain the exchange rates undervalued, they have to create money. In every case, new money would expand credit and broad monetary aggregate, fuelling the domestic bubble. My conjecture is that, it will end up pretty ugly in China, just like 1929 and 1989.
3. Inflexible Monetary System and Bubbles
The above mentioned problems with currency peg/gold standard exist for the Hong Kong dollar linked-exchange rate mechanism as well. The US dollar has been depreciating in value since 2001. In order to keep the Hong Kong dollar exchange rate in-line with the drop of the US dollar, all else being equal (let’s say, no net capital flow, no trade surplus/deficits), the Hong Kong Monetary Authority would have to intervene: creating more money. That means that over the past 10 years, we see increasing liquidity in the banking system. That is manifested in not only the lower rates of the interbank rate, but, I believe, also the spread between the mortgage rates and funding costs. Together with the new liquidity source from China, they increase the monetary base and monetary aggregate, particularly in the past 2 years, fuelling the property boom.
It is all about liquidity, money and credit. The two biggest questions that nobody is asking concerning Hong Kong property market: 1. What if China boom comes to an abrupt end? 2. What if US dollar strengthen?
To address the first question, the above discussion should tell you that if my conjecture turns out to be right, there is very little luck for Hong Kong property, needless to explain.
The second, this is yet another contentious contrarian call: long US dollar. The Hong Kong property bubble of the last two years is in part driven by the intense dislike of Ben Bernanke, who is allegedly printing a lot of US dollar. Fearing that the US dollar got “debased”, people short US dollar for other things. In reality though, we do not see the broadest monetary aggregate rising much in the US, implying that the future of the US economy will be, controversially, deflationary. The lesson of Japan tells you that under such environment, quantitative easing would not work, and the Japanese Yen has been rising in value for the last 10 years. My conjecture is that the US is down to that road. In fact, it you look at the dollar index, after it hit the bottom in 2008, it has moved sideways for 3 years despite the intense dislike of the US dollar.
The implication for a strengthening US dollar is that, all else being equal, if Hong Kong dollar peg remains at the rate of HK$7.8 per US$, a rising US dollar means that the Hong Kong Monetary Authority will have to contract monetary base in order to keep the exchange rate in-line with the strengthening US dollar. Liquidity will be out. At that time, my belief is that not only you might see HIBOR going up as liquidity is squeezed, but also the spread between mortgage rates and funding costs. We have been too accustomed to mortgage rates at 3% below prime. That era is close to an end.
I recently have the joy of reading some of those really old research reports published back in 1997, literally on the eve of the epic property crash. Needless to say, most of them were bullish, unlike today, as we can still find a few lone voices of bears. That said, we still see some interesting parallels.
Property stocks peaked in late 1996, quite similar to today, as property stocks peaked in late 2010
Property prices showed weaknesses since mid-1997. Not too far off today.
Developers bided more conservatively in 1997 after government promised more land supply. Also not too far off today.