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Thursday March 24, 2005 - 11:30:31 GMT
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China as dollar catalyst


“Is it not a pleasure to learn and to repeat or practice from time to time what has been learned? Is it not delightful to have friends coming from afar? Is one not a superior man if he does not feel hurt even though he does not feel recognized?


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“Property lending is the major income source for the Shanghai banks, which believe the lending risk is low because borrowers pledge the properties themselves as security for their loans,'' said Winnie Yun, general manager of Centaline China. Yeah! The “risk is low.” Sure! OK! And if you believe that, I have some very nice Florida swampland available to the highest bidder.

Beijing doesn’t seem to feel the “risk is low.”

“Following the Shanghai government's imposition of a 5.55 percent capital gains tax on the sale of homes owned for less than one year, the banking association announced Wednesday last week a set of measures in support of the government's efforts. These included refusing to lend for the purchase of any home that the seller has owned for less than a year and to lend for third homes, and raising mortgage thresholds for foreigners and mainlanders from outside Shanghai,” according to The Standard.

The banks in Shanghai know they must keep the music playing…

“China’s property market is massively overbuilt, and demand is mainly for speculative inventory. Residential properties under construction reached 1.1 billion square meters last year. This implies about 15 million properties under construction compared with 166 million urban households. With the price/household income ratio substantially above 10, final demand cannot possibly be so high.

“Instead, the demand is mainly from inventory holdings for price speculation. There are no reliable statistics on the share of speculative demand in total demand. My own guesstimate is between one-third to one-half based on two observations. First, I have seen a large proportion of sold flats remaining empty wherever I go. Second, anyone I know who has bought a property in the past few years probably owns multiple flats,” writes Andy Xie of Morgan Stanley.

And why does any of this China stuff matter when it comes to the dollar? Good question!

I and others who don’t have any investment banking business, or other business for that matter, to worry about, believe China is in big time financial bubble trouble. And if Mr. Xie and others are correct, that much of the money rushing into China is predicated on the property boom, the new face of the Fed i.e. more aggressive in light of inflation expectations, pushes up the timetable for Chinese bubble bursting.

From Reuters today: “’Earlier on Thursday state media said a recent report by the central bank's research department had cited bubbles in the real estate and manufacturing sectors as possible risks to banks and the currency. The problems of huge invisible financial losses and excessively large economic bubbles are all latent factors resulting in instability in the value of the currency,’ the Shanghai Securities News quoted the report as saying.

"’If the economic bubble bursts, the banks will be left with a huge amount of bad loans, which will affect the stability of the currency,’ it said.”

A Chinese hard landing, or rising sentiment about a Chinese hard landing, adds real fear, besides just economics, into the carry trade equation. And we all know that fear is an even greater motivator than greed. As you know, I view the Aussie dollar (and Kiwi) as a proxy for the global carry trade. I think this chart below captures many of the dynamics in play:

chart: Aussie/2yr note futues/crb index

This chart shows the Aussie has benefited from a few primary themes and it emboldened the carry trade crowd:
1) As the Fed pushed rates lower, the Aussie benefited from yield advantage relative to the dollar (that can be seen in the rising blue line i.e. lower 2-yr T-note yields). So it was a slam dunk to borrow dollars and buy Aussie it seems.
2) And the rising blue line dumped massive amounts of liquidity into the global economy. This liquidity was quickly channeled into commodities thanks to the catalyst of Chinese demand. And again, the Aussie benefited from the flow into commodities.

But now, this tidy little virtuous circle could turn quite vicious. Two primary reasons, and again they are linked through the magic of interest rates: The Fed seems serious about taking away liquidity and the catalyst for commodities demand—China—could soon be hitting a bump in the road.

Jack Crooks


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