Pumped With Cash – And Ready to Crash?

China's foreign exchange reserves soared by US$ 453 billion in 2009, or 10 percent of 2008 GDP. Bank lending increased 32 percent to 9.6 trillion yuan. And yet nominal GDP rose only about 5 percent.

Clearly, the financial side drove China's GDP growth last year, reflecting a new reality of the post-financial crisis world. But all that money produced relatively little GDP growth because it worked its way into a single sector: property.

Two market beliefs animate this continuing movement. First is the belief that China's currency will only appreciate. The other is that China's land prices will drive money flows.

The currency argument is based on cross-border capital flows. Capital inflow -- not trade surplus, which fell by one-fourth from 2008 – drove China's foreign exchange reserves in 2009. One data point was a surge in reserves before U.S. President Barack Obama's China visit last November. Many hedge funds were positioned for yuan appreciation during the visit. When expectations were disappointed, the flow slowed. Slower growth for reserves in December supported this observation.

The second belief exerts a powerful effect on domestic capital flows. New property sales rose 75 percent year-on-year and topped 14 percent of real GDP in 2009 – a first for China or any major economy. Household savings were between 20 and 25 percent of GDP. It is easy to tell from property sales data where household savings are going.

On the business side, there has been an equally major shift in capital deployment. A proliferation of land barons – tycoons who broke all records at 2009 land auctions – showed where business investment was heading. Their eagerness for land hoarding was illustrated by an unusual yet widespread phenomenon: In any given area, land costs exceeded prices for existing developed property. This is why I suspect most bank lending last year was related to property.

Each belief depends on the key assumption that the Chinese government will let neither exchange rates nor land prices fall. The market psychology that the Chinese government is capping the downside for speculators has emboldened them to speculate in any asset class with a China angle.

Yet the assumption has not been tested because the U.S. Federal Reserve's low interest rate policy continues to drive money out of dollars and into China-related assets. When inflation forces the Fed to raise interest rates quickly, probably in 2012, this assumption will be tested. In the current speculative game around China, the force is the Fed's zero interest rate. When that changes, I suspect few of today's speculators will be around.