From The President: A History Lesson “Unconventional Wisdom”

Highland Capital Management’s co-founder and President James Dondero describes how many of the causes of the Asian financial crisis of the late ‘90s are present to an even greater extent in China.

Shakespeare didn’t have the financial markets in mind when he wrote that “what’s past is prologue,” but the words still ring true – especially when it comes to the bubble waiting to burst in China. Many of the underlying causes of the Asian currency and debt crisis of the late 1990s in countries like Thailand and South Korea – one of the worst sovereign financial disasters in history – have resurfaced to a greater extent in China. Among these are money supply growth outpacing GDP and reserves, aggressive lending, excessive infrastructure and real estate investment, and significant “hot money” inflows. In many ways, these excesses are more glaring than those behind the 2007 subprime market collapse – and the consequences are likely to be harsher.

Conventional wisdom holds that China’s currency is undervalued because of large foreign exchange reserves, a trade surplus, high savings rates and overall economic strength. In reality, the key factor is China’s ever-expanding money supply (M2), which has increased, on average, almost 22 percent a year between 2002 and 2010 and nearly 26 percent annually during the last two years. By contrast, U.S. M2 rose only 6 percent and 3 percent, respectively. These figures reveal that recent consumer price inflation in China of 5.4 percent (vs. 1.2 percent in the U.S.) cannot be attributed to the dollar peg or implicit adoption of U.S. monetary policy. In the aggregate, China’s M2 is 20 percent larger than the U.S., but its GDP is 61 percent smaller.

China’s foreign currency reserves, at $3 trillion, are low relative to M2 – another warning sign. According to official statistics, China’s reserves as a percentage of M2 were only 26 percent at the end of 2010 (the actual percentage may be substantially lower). By comparison, the reserve ratio in Thailand was approximately 30 percent when speculators began betting against its currency in 1997. Reserve liquidity is equally important. Countries like the U.S. and Japan publish transparent statements outlining their foreign reserve holdings, allowing observers to evaluate the reserve liquidity. It should be no surprise that China is far more opaque, obscuring the composition, encumbrances, and availability of reserves.

Full Story – From the President: A History Lesson

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