China: Bubble on the Horizon?

A new paper has been released by former Morgan Stanley Analyst Andy Xie that is garnering much chatter in the blogosphere. It addresses two of my favorite issues, China and the dollar. Surprisingly, the author is bearish on the former and bullish on the latter. 

The paper, via Big Picture, is well worth reading in its entirely. Xie's assertions are quite harsh:

Chinese asset markets have become a giant Ponzi scheme. The prices are supported by appreciation expectation. As more people and liquidity are sucked in, the resulting surging prices validate the expectation, which prompts more people to join the party. This sort of bubble ends when there isn’t enough liquidity to feed the beast

What will break this bubble? Xie believes that a dollar appreciation, triggering an outflow of capital from China, would be enough to pop it:

It is not too hard to understand when the bubble would burst. When the dollar becomes strong again, liquidity could leave China sufficiently to pop the bubble. What’s occurring in China now is no different from what happened in other emerging markets before. Weak dollar always led to bubbles in emerging economies that were hot at the time. When the dollar turns around, the bubbles inevitably burst.

It is difficult to tell when the dollar will turn around. The dollar went into a bear market in 1985 after the Plaza Accord and bottomed ten years later in 1995. It then went into a bull market for seven years. The current dollar bear market began in 2002. The dollar index (‘DXY’) has lost about 35% value since. If the last bear market is of useful guidance, the current one could last until 2012. But, there is no guarantee. The IT revolution began the last dollar bull market. The odds are that another technological revolution is needed for the dollar to enter a sustainable bull market.

Xie posits that a dollar rally could also take place if the Fed were forced to significantly raise interest rates. This would be due, in all likelihood, to inflationary pressures caused by its policies during the crisis. This tightening of the money supply and subsequent dollar strengthening would be a replay of Volcker's Fed in the 70s and 80s. 

Are there any other possibilities for a flight to the dollar?

Xie fails to mention the recent dollar bull market we experienced last fall. A future crisis could spark another rise in the dollar, if the dollar continues to be investors' principal safety instrument. Furthermore, unlike the other two scenarios, where China could simply use its massive pile of dollar reserves to suppress a dollar bull market, a second financial crisis would simultaneously boost the dollar and pull capital out of markets that are seen as too risky, such as China's. 

Under this scenario, China's reserves might not be enough to prevent investor flight.