Ben Bernanke's recent press conference and China's interbank market crash may appear to have little in common but the truth is rather different. For both the U.S. and China are trying to deflate asset bubbles caused by excessive money printing and interest rates being kept too low for too long. And politics is largely behind the timing of their decisions to clamp down on these bubbles. Bernanke is desperate to avoid the mistakes of his disgraced predecessor, Alan Greenspan, whose loose money policies blew up soon after he departed the post. And China's President Xi Jinping would rather have an economic slowdown now than later on so that he can blame it on his predecessor, Hu Jintao.
The question for investors is whether Bernanke or Xi will blink, choosing to reflate their asset bubbles (the U.S. bubbles are principally in stock and bond markets while China's are more broad-based) rather than face the consequences of unwinding them. At Asia Confidential, we're not certain of anything. But our best guess is that the U.S. economy is too fragile and deflationary forces are too strong for QE tapering to take place this year. China is a different matter as we now suspect the new president may just have the political backing and will to carry out tightening measures. Either way though, the asset bubbles in both countries are likely to deflate, it's just a matter of how and when this happens.
The context to market gyrations
What's behind the wild market gyrations of the past week? It's clear that the U.S. and China are attempting to deflate their asset bubbles and markets don't like it. To better understand why this is the case though, it's important to appreciate how these bubbles developed in the first place.
And to do that, we need to step back in time. All the way back to 1994, in fact. Why this year, you ask? Well, it's then that China devalued its currency by 50%. Asia Confidential believes that this singular event has been the key driver behind events leading up to the financial crisis and thereafter.
That's because the 1994 devaluation resulted in a substantial under-valuation of the yuan. This under-valuation created the conditions by which China was able to become an exporting powerhouse.
For China to become this powerhouse though, it needed buyers. The developed world was only too happy to oblige, scooping up the cheap Chinese products. It didn't matter that consumers in the developed world didn't have enough money to purchase all of these products. They simply piled on debt to pay for them.
The beauty of this arrangement was that China received U.S. dollars from U.S. consumers. Its subsequent trade surplus led to the rapid accumulation of foreign exchange reserves, which China used to buy U.S. government bonds. This in turn kept U.S. bond yields and interest rates low, making it cheap for U.S. consumers to take on more debt to buy Chinese products and other things (such as local property).
But to maintain its currency peg to the U.S. dollar, China had to create yuan through the printing press. This whole process helped created inflation at home and deflation abroad.
An elegant arrangement, no? Not so much. Since 2008, this seemingly virtuous circle has slowly unravelled as the developed world pays down its excessive debt load. Meantime, political pressure to appreciate the yuan has resulted in that currency recently reaching 19-year highs versus the dollar.
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