China needs QE3

Beijing To Bernanke: Bring On QE3, Fast

There is a country that, more than any other, needs the Federal Reserve to embark on QE3. It is not the U.S., however.

Gordon Chang

Forbes,

9 September, 2012

In America, two rounds of quantitative easing, in 2008 and 2010, have produced only mixed results. Chairman Ben Bernanke has not been able to create sustained growth, and unemployment has stubbornly remained at high levels.

Unfortunately, the prospect for the next round of Fed stimulus is not great. Now that the U.S. has already been flooded with liquidity, more easing is unlikely to have much positive effect.

QE3 may not help the U.S., but China certainly stands to gain. For one thing, Beijing these days needs a weak dollar.

In the past, the Fed’s massive balance sheet operations have driven down the value of the greenback, and talk of QE3 has, not surprisingly, further undermined the American currency. On Friday, the dollar hit a near four-month low against the euro after the weaker-then-expected jobs report in the U.S. opened the door to another round of Fed easing, which could come as early as the next Federal Open Market Committee meeting on the 12th and 13th of this month.

Color the Chinese happy. The People’s Bank of China, the country’s central bank, essentially pegs the renminbi to the greenback. A weak American currency means a weak Chinese one, and a weak Chinese currency helps the nation’s struggling exporters on global markets. In July, China’s exports increased by only 1.0% year-on-year, and the expectation is that the August export figure, scheduled to be released in a few hours, will not be appreciably better.

Beijing is in the midst of helping export factories by cheapening its currency. The yuan, as the renminbi is informally known, has fallen 0.9% against the dollar this year with most of the decline taking place in the second quarter. That downward movement is almost certainly the unannounced part of Premier Wen Jiabao’s plan, which he publicly discussed August 25, to use exports to pull China out of its current economic predicament. So Chinese leaders, who used to be upset at the declining dollar, now cheer its weakness.

Yet there is a more fundamental reason why they must be eagerly awaiting this week’s FOMC meeting. In the last round of quantitative easing, Beijing was upset at Big Ben Bernanke because QE2 cash was crossing the Pacific and aggravating China’s asset bubbles. Now, however, share prices have deflated, returning to pre-bubble valuations.

At the end of last month, Chinese stocks hit 42-month closing lows on concerns over the quickly deteriorating economy. To revive growth, the National Development and Reform Commission last Wednesday and Thursday announced the approval of 60 infrastructure projects costing 1 trillion yuan, about $157 billion. In four years, the country will have many more highways, ports, and runways than it does today.

Analysts see significance in the NDRC’s announcement. “It signals a change in policy stance, which is now much more proactive,” said Zhang Zhiwei, a Nomura economist in Hong Kong, to CNBC.

On Thursday, Chinese stocks reversed a losing trend, and on Friday they took off, with the Shanghai Composite skyrocketing 3.7% that day. The jump, the biggest daily gain since January 17, was across the board. Steel futures rose as did copper prices. Sany Heavy Industry, China’s largest construction machinery manufacturer, and Anhui Conch Cement, the country’s biggest cement maker, had stellar days. Global markets also reacted positively because, as CNBC’s Bob Pisani noted, news of the Chinese stimulus had not been priced in.

In fact, there is a lot of information that investors have not digested. A similar spate of NDRC announcements in May had no noticeable effect on the economy, many of the newly approved projects are grossly wasteful, and some of them will take years to build because they conflict with local plans. Furthermore, the NDRC’s new approvals will further unbalance an economy that is already dangerously skewed toward government investment. In any event, the new stimulus is not enough to make up for falling industrial production. Perhaps most important, it is not evident how all the new projects will be paid for. It appears the NDRC contemplates that debt-laden banks and bond-market investors will pick up the large tab.

If central government technocrats are reluctant to pay for all the building they have authorized, will foreign investors, cashed up by QE3, have confidence in the Chinese stimulus program and the economy itself?

The economy is especially troubled, which is evident from the first tranche of August data. The statistics, released just a few hours ago, shows on balance no improvement from July’s disappointing results.

Especially telling was the 3.5% year-on-year fall in producer prices. Also of concern was the tiny 2.7% increase in the production of electricity. Because the growth in electricity production has historically outpaced the growth of the economy, the power number points to an essentially zero-growth economy.

Despite growing evidence of a contracting economy, sell-side institutions are bullish on China. Take HSBC, for instance. Philip Poole of HSBC Global Asset Management believes Chinese equities have been oversold as fears about the economy have been “overstated.” Moreover, HSBC points out that Chinese companies are trading at 0.7 times forward earnings and are cheap compared to Italian and Spanish corporates, now priced at 0.9 times.

But Chinese stocks are cheap for a reason. The issue is whether they have found their bottom. The general view among China market analysts is that capital will go to China in anticipation of a recovery.

That’s where Bernanke comes in. He can create a tidal wave of liquidity that will sweep westward across the Pacific, like he did in 2010 with QE2. Poole last week said China’s equity markets will benefit from new QE3 capital arriving from America. He is probably wrong because today China, unlike 2010, looks troubled.

And Chinese leaders are evidently running out options. You know they’re in trouble when analysts think Bernanke is Beijing’s best hope.