Financial Times Nov 3 2009
http://www.ft.com/intl/cms/s/0/39f61cb6-c818-11de-8ba8-00144feab49a.html#axzz1WV4KM3Sy
Emerging markets, it seems, have had a good crisis. In contrast to the debt-ridden G7 economies, they have quickly resumed their growth trajectory. No surprise, then, that US emerging market mutual funds are experiencing record inflows. The stellar performance of the Brics markets – Brazil, Russia, Indian and China – is due to continue into the distant future.
Such is the narrative now forming among investors. To anyone who has lived through the rise and fall of the Japanese bubble economy, it should set off alarm bells.
Remember that it was in the years following the 1987 “Black Monday” crash that Japanese assets went from being expensive to absurdly overvalued and the Nikkei’s dizzy rise to 39,000 forced the bears to throw in the towel.
Then, as now, the logic seemed unassailable. While the western world was stuck in the post-crash doldrums, the Japanese economy had got back on track with apparent ease. Japanese corporations were using their high market capitalisations to finance acquisitions of foreign trophy assets. Japanese banks boasted the world’s strongest credit ratings.
But what you saw was decidedly not what you got. The crisis, far from leaving Japan unscathed, exacerbated its structural problems and laid the groundwork for a far greater disaster. And it was the weak western economies, not Japan, that produced healthy investment returns over the next decade.
In reality, 1980s Japan was never going to be terminally damaged by weakness in export markets. Its current account surplus and strong fiscal position provided the macro policy leeway to make any slowdown strictly temporary. The Bank of Japan duly put the pedal to the metal and the recently deregulated banks went on a patriotic lending spree. High-end consumption boomed but the real action was in the asset markets and capital investment, which soared as a proportion of gross domestic product.
Sound familiar? It should, because the same dynamic is evident today in China and some other emerging economies.
Interest rates have been far too low for far too long. If the natural interest rate is, as the Swedish economist Knut Wicksell posited, around the level of nominal GDP growth, then China’s interest rates should have been close to 10 per cent for most of this decade. Alan Greenspan, former chief of the US Federal Reserve, has been criticised for holding interest rates too low and setting off a housing and credit bubble in the US. But if US monetary policy was wrong for the US, it was even more wrong for the high-growth countries that “imported” it. The result could only be a massive misallocation of capital.
At the 2008 peak, the price-to-book ratio of the Shanghai stock exchange was over seven times, well above the five times achieved by Japanese stocks in 1989. After the turbulence of the past 18 months, the ratio has fallen to 3.3 times, still the world’s second highest after India, and residential real estate trades at multiples of income that make the US housing boom look tame. Bulls justify such lofty valuations by plugging high growth numbers into their models. Historically, however, the linkage between high GDP growth and investment returns is tenuous. The years of the Japanese economic miracle saw poor stock market performance, and the market indices of high-growth economies such as Korea, Taiwan, and Thailand have made little progress for 20 years in dollar terms.
What is scary is that the current frothiness of emerging markets, centred on China, may be only a taste of what is to come.
For most of the 1980s, Japan, like China today, used government direction of bank credit (“window guidance”) to overlay monetary policy. It was the combination of banking deregulation and the G7-sanctioned surge in the yen that ushered in the final manic stage of the Japanese bubble.
At its peak, the grounds of the Imperial Palace in Tokyo had a greater theoretical value than the entire state of California. By then there was no way out – asset market collapse and financial system wipe-out were baked in the cake.
If China continues to follow the Japanese template, the end of the dollar peg will be the trigger event, setting off a Godzilla-sized credit binge. Why would China’s rulers embark on a such a disastrous course? Because the alternative – unleashing deflationary forces stored up over years of mercantilist policies – would be too painful to contemplate. That was the choice made by Japanese policymakers, who had 100 years’ experience of managing a quasi-capitalist economy.
This time the denouement would be one of the biggest bubbles in history, probably in scale and certainly in number of people involved. Could China weather the subsequent financial turmoil as stoically as Japan? It seems unlikely; at the least its ascent to global hegemony would suffer an interruption
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