#59. Storm Front – part 4 (of 3)

A MATTER OF MOMENTUM

A long time ago, a certain rock band released an album titled Three of a Perfect Pair. I’ve never heard the album, but I now know the feeling – because here is Part 4 of the Storm Front trilogy.

To explain, I saw Storm Front as a three-part investigation. It would look at why there might be a financial crash in China; at what its broader implications might be; and at what reactions might be appropriate. Since then, readers have made some very important points; the broader debate is accelerating; and market indicators are making my timing look either good or fortuitous.

As we know, the Chinese stock market keeps trending down, even though the authorities have thrown at it, not only the kitchen sink, but the full might of Chinese law. In itself, this isn’t too important. China’s stock market is pretty modest in comparison with the economy and, in any case, the Index has only surrendered part of its earlier gains. Moreover, stock markets themselves are minnows in comparison with bond and forex markets, which is where the really big money is.

What, then, is the important story behind China’s stock market wobbles?

What’s the context?

Since you’ve probably read the previous instalments, here’s a very brief heads-up on the big issue. That issue is debt.

In the years before the 2008 crash, global borrowing (excluding the inter-bank sector) totalled $38 trillion, or $2.20 for each $1 of growth at that time. Since then, we’ve borrowed $49 trillion, or $2.90 for each growth dollar. Moreover, even that growth metric is highly debateable, since this “growth” was really nothing more than the spending of borrowed money.

In other words, far from learning from 2008, we’ve actually increased the rate at which we borrow. One reason for that is that the authorities responded to the banking crisis by making borrowing easier and cheaper. Another is that, aside from spending borrowed money, we seem to have lost the ability to grow the economy.

Where does China fit into this?

Back in 2008, the one bright spot in a pretty dark global economic picture was that China was growing very rapidly indeed. Some argued that a broader group of emerging economies – the BRIC countries – might take over from a debt-shackled West as the main driver of the global economy. Since then, two of the BRICs – Brazil and Russia – have fallen by the wayside, and opinions differ about India.

Until recently, though, China has lived up to its billing as a – indeed, the – global driver of growth. GDP has continued to power ahead. Foreign capital has poured into China, seeking better returns than can be earned in the West. China has sucked in vast amounts of commodities, and of industrial goods. In the space of just three years, China’s consumption of cement exceeded that of America in the whole of the twentieth century. Though China remains a net exporter, its imports have risen rapidly, so that China’s net trade surplus is down to barely 2% of GDP, down from 10% less than a decade ago.

Without all of this stimulus from China, it is debateable whether there would have been any growth at all in global GDP since 2008.

But the weaknesses in what China has been doing are now showing up. For a start, growth has fallen markedly. The Chinese authorities say that growth is now 7% – exactly where they said it would be – but hardly anyone now believes this. Volumetric measures, from vehicle sales to factory output, are dropping rapidly.

And the big snag, as ever, is debt. Since 2007, China’s GDP has grown by $5 trillion, but its debt has increased by $15 trillion, even when we exclude a big ($5 trillion) rise in financial sector indebtedness.

In other words, China since the crash has been doing what the West was doing before it – spending borrowed money and calling this growth. In a sense, this debt-funded growth is real – they’ve got the roads, the factories, the shopping centres and the homes to show for it – but, where such things are concerned, GDP only measures what has happened. It doesn’t tell us whether investment has been worthwhile or not.

What’s the problem?

In the years running up to 2008, real estate was the West’s “idiocy-of-choice”. We poured money into inflating the value of our housing stock, and did this in some very dangerous ways (such as lending to people who could never pay it back, or even keep up the payments after initial “teaser” rates had expired).

Though China, too, has inflated its property market, its main area of excess has been using debt to build capacity that nobody wants. Surplus capacity invariably drives prices down, which is why China’s important local government development vehicles are now earning a return of 2% on assets which cost 6% to service. The clear danger is that China’s debtors cannot keep up the payments on their loans, because surplus capacity has crushed the income on the assets they’ve created with that debt.

Reflecting this, capital is pouring out of China at a rapid and accelerating rate. Forward indicators (such as shipping rates) are pointing unmistakably to a severe economic downturn. That’s a problem for the ruling party, whose “grand bargain” with its people trades liberties for prosperity.

But it’s just as big a problem for the rest of the world. Worries about Greece fade into near irrelevance beside China, to which global banks’ exposure is about 17x greater. Thus, debt going bad in China could hit the global financial system just as the global economy loses its big driver.

Can we, or China, cope?

In short, no.

China’s government debt – about 50% of GDP – is pretty low, but then that was true of America, Britain and the rest before 2008. Government debt ratios tend to soar after a crisis, not before it. China has big reserves, but these consist largely of American government IOUs – so, even if these reserves help China, which is doubtful in itself, they won’t help the global financial system.

In 2008, we responded to a debt problem by borrowing still more. QE (“quantitative easing”) involved buying bonds using money newly created for the purpose. This drove bond prices up, and therefore pushed bond yields – the global market’s interest rate – downwards. This, together with near-zero official (“policy”) rates enabled borrowers to keep up the payments – but it also provided an incentive to borrow even more. This in turn pushed property and other prices up.

Is there a “keystone” problem here?

The really big problem is the disconnect between income on the one hand, and capital values on the other. For example, house prices have soared to very high multiples of average earnings. This has happened across the board, right the way from household debt ratios to the global relationship between GDP and debt. (It has also, by the way, widened the gap between the rich and everybody else, but that’s another issue).

This imbalance is not sustainable. It is the equivalent of an old lady with a big house but little income, who is “asset rich but cash poor”. Unlike that old lady, who could at least sell her big house, the global system has no such possibility. The only people we can sell our inflated assets to are ourselves.

What happens now?

The asset-income disconnect means that we have three options.

First, we could boost our income. Unfortunately, and apart from borrowing yet more, we don’t know how to do this.

Second, we could let asset values crash, but this would be disruptive, and extremely unpopular. Logic suggests that it has to happen, but it will be resisted by all means available.

Third, we could cheat, which means injecting more and more money into the system to keep it going. There are two problems with this. First, this would only buy time. Second, it risks destroying the trust without which “fiat” (mandated) money has no value.

The best guess has to be that policymakers and central banks will try the third option – tinkering – but that it won’t work. There has to be a likelihood that people won’t fall for this a second time.

And in the near-term?

China is the lynchpin, not just because of the sheer scale of its debt, but also because its growth has carried the global economy since 2008.

The likelihood now has to be that the deterioration, in China and elsewhere, will gather momentum. Already, there are reports that China has had to bail out some parts of its huge shadow-banking sector. The economic downturn, traceable in large part to unprofitable surplus capacity, seems likely to gather pace. Even for China, bail-outs might turn out to be like pouring ever more water into a leaky bucket.

These trends tend to have a momentum which gathers pace. Perfectly viable borrowers can become non-viable because of the failures of others by whom they are owed money. As somebody once said, when everyone starts running for the exit doors, those doors get smaller.

What this all means is that a crisis now increasingly seems likelier than not. Short of a crystal ball, it is impossible to know when this will happen. The coming autumn looks a possibility, but – based on the experience of 2007 and 2008 – there might a window of as much as a year before things go wrong.

At least, “forewarned is forearmed”.

#58. Storm Front – part 3

WHY RESPONSES TO THE LAST CRISIS WON’T WORK NEXT TIME

In the first part of this series, I explained why I regard China as a financial disaster waiting to happen. In the second, I looked at what the broader consequences might be. Here, I turn to what should be done when the next financial crisis explodes.

That a new financial crisis will explode increasingly seems probable. The world’s solution to a massive debt problem has been to borrow even more, and the numbers make it painfully clear that this isn’t going to work. Looking around the world, the “storm cones” seem to be being hoisted in an increasing number of places.

The key conclusion here is that repeating the policy responses of 2008 will not be possible and, more to the point, would not be desirable anyway.

Interest rates that are already at zero cannot be cut further and, in any case, ultra-low rates, engineered using QE, have helped to make a new crisis virtually unavoidable.

Governments are now far more indebted than they were in 2008, so bailing out the banking system, even if it is possible at all, will have to be done very differently. It will not be feasible this time to duck costs that were evaded in 2008. Any further tinkering with the fiat monetary system would run a high risk of destroying it altogether.

What, in my opinion, has to happen this time is an acceptance of the challenge rather than a strategy of “extend and pretend”. Where bank support are concerned, it will not be possible for governments to take over banks as if they were going concerns, preserving their structures and compensating shareholders at something approximating to market value. This time, governments will need to preserve the ‘utility’ elements of banks and backstop depositors.

If, as seems likely, property prices are one of the bubbles that burst, a possible counter to negative equity may be to offer voluntary conversion from (negative value) ownership to rental status. The banks would avoid massive write-offs, homeowners would be freed from negative equity, nobody need be rendered homeless, and the market would not be deluged by forced sales. Big write-offs could thus be limited to mortgages on buy-to-let and second homes.

Above all, we are in clear need of responses planned in advance, which was not the case seven years ago. This time, when there is even less excuse for a lack of preparedness, policymakers and central banks need to find something better than “extend and pretend”.

The charts below provide a snapshot explanation of why a new crisis looks very likely. In the period between 2000 and 2007, global debt increased by $55 trillion, or $38 trillion if we consider “real economy” debt, rather than inter-bank borrowing. Since 2007, debt has grown by $57 trillion, of which real economy borrowing accounts for $49 trillion.

Having taken on $2.18 of real economy debt for each dollar of growth in the earlier period, we have since increased this to almost $3.

This is insane.

And even this metric understates the real scale of the problem, because most of the “growth” is actually nothing more than the spending of borrowed money, and will, therefore, reverse, if we are ever forced to stop borrowing.

In a nutshell, then, a financial system that found itself in a hole has carried on digging.

What went wrong last time

Seven years having elapsed since the banking crisis, we are now have a perspective from which to summarise how the world responded.

Two things are clear.

First, the responses to the 2008 crisis haven’t worked.

Second, we could not now repeat those responses, even if we were foolish enough to try.

The basic problem in 2008 was one of too much debt. More specifically, it was too much of the wrong type of debt.

Not all borrowing is bad. Essentially, “good” debt is self-liquidating. If the owner of a successful restaurant borrows to add extra tables, the increased income will pay off the debt. Borrowing to increase your skills should boost your future earnings, enabling you to pay off the debt. Mortgage debt, prudently managed, has made home ownership possible for millions.

Unfortunately, in the years before 2008, the financial system proved increasingly ingenious at pushing the wrong kind of debt. There are many bad forms of debt. A bad debt may be one that the borrower simply cannot afford to repay or, worse still, cannot even afford to service. Borrowing for consumption rather than for investment is generally a bad idea. Borrowing for speculation isn’t a great idea either. Separating risk from return tends to be disastrous, as does borrowing to inflate asset values.

All and more of these forms of bad lending proliferated in the run-up to the crisis. Thanks to the disastrous repeal of the Glass-Steagall Act at the end of 1999, and of its equivalents elsewhere, banks were now allowed to own securities operations which, increasingly, became debt-pushers as banks created “profits” by destroying their own balance sheets.
Sub-prime mortgages, bad enough in themselves, became worse when primed to self-destruct (as Adjustable Rate Mortgages or ARMs), and worse still when packaged into securities which, ludicrously, were accorded investment-grade ratings. These securities were a disaster, first because investors didn’t really know what they were buying, and second because they enabled the separation of risk and return.

More generally, property markets were inflated by the influx of easily-available lending, much of it made possible because previous rules on loan-to-value (LTV) and loan-to-earnings ratios were relaxed.

There is something that we – unlike, it seems, bankers and politicians – need to understand about mortgage lending. Say that Mr X can afford mortgage payments of $5,000 per year. On an interest-only basis (to keep it simple), this means that he can afford to borrow $100,000 if the interest rate is 5%. Lower the rate to 2%, however, and he can now borrow $250,000.

Unfortunately, just as Mr X can now afford to borrow much more, so can everyone else. So, instead of buying a better house, he can really only buy the same house for more money. So property prices at any given time are a function, not of supply and demand, but of the amount, cost and ease-of-access of mortgage funds.

This mountain of debt, dangerous in character as well as in sheer size, began to wobble in 2007 – when bankers began to find it difficult to know which other banks they could trust – and fell over completely in 2008. As the wholesale debt markets seized up, bad debts were crystallised and the banking system teetered on the brink of a black hole.

What we did wrong

If circumstances change for the worse, borrowers can easily become engulfed by too much debt. The fact that they cannot repay it is the second problem, not the first. The really pressing issue is keeping up the payments. Having more debt than you can repay is insolvency, but being unable to meet interest payments is illiquidity, and that can be far worse.

This presented policymakers and central bankers with three immediate problems.

First, a vast swathe of banks were insolvent and, far worse, faced becoming illiquid.

Second, borrowers were unable to keep up interest payments, something which, if it happens on a big enough scale, creates bad debt write-offs that can easily destroy banks’ entire loss-absorbing capital (which was, and remains, far too small anyway).

Third, economies pumped up by activities such as real estate and finance could suffer severe setbacks, making the debt-servicing problem even worse.

Governments and central banks acted, first, to prevent panic, partly by guaranteeing deposits but principally by intervening, either taking banks into public ownership or foisting them off onto solvent but gullible competitors. In Britain, for example, the state had no real choice but to take over Northern Rock and the Royal Bank of Scotland, both of which had followed very risky business models. Shareholders were compensated at something approximating to the share price, and structures were kept intact, meaning that most senior executives, though chastened, kept both their jobs and their assets.

Simultaneously, central banks cut their policy interest rates virtually to zero. There was some Keynesian calculation here – lower rates act as a stimulus – but the main aim was to prevent borrowers from going bust. Fiscal policy loosened dramatically, less as a deliberate act of strategy than as a simple consequence of tax income crashing and welfare costs rising.

Central bankers soon realised, however, that cutting policy rates wasn’t going to be enough, because interest rates are really determined by bond markets. If these fall, rates (which are the yields on bonds) rise. Conversely, if bond markets can be pushed higher, market interest rates will fall. For this reason, central banks resorted to QE (quantitative easing) on a huge scale, inflating bond markets (and thus manipulating yields downwards) by buying bonds using money newly created for the purpose.

Unfortunately, none of these measures was a permanent fix. Government debt ratios increased dramatically, as did fiscal deficits. The banks – and the bankers – were bailed out with cheap funds, which for the most part they were encouraged to lend. In most countries, really severe falls in property prices were prevented. Mortgage payments fell sharply, bailing out the reckless at the expense of savers.

It should be no surprise at all that of this restored, not just a semblance of “business as usual”, but ‘recklessness-as-usual’ too. Bond markets soared – an intentional policy outcome – and ultra-low costs prompted a renewed surge in borrowing.

Seven years on, very little has changed. Property and other asset markets are even more inflated than they were in 2008. Government debt ratios have soared, and getting annual borrowing back down has proved a long slog. Economic recovery has been lacklustre, and even such growth as has been achieved is mostly phoney, amounting to nothing more than the spending of borrowed money.

Western economies remain on a treadmill of borrowing to grow – in Britain, for example, official projections indicate that the economy will grow by a nominal £500bn over the coming five years, but only if households go on a £330bn credit binge as well as borrowing a further £500bn in order to inflate house prices by another 35%.

Just as the Western economies have reverted to type, the hope that emerging economies might become the new drivers of the global economy have proved false. Three of the four much-vaunted “BRICs” – China, Brazil and Russia – are crumbling as we watch. India aside, these countries are vindicating the minority who, all along, suspected that the fashionable enthusiasm for the BRICs might not stack up.

What could we have done instead?

Alternative history can be an absorbing read. There are very interesting books which postulate, for example, a successful German invasion of Britain in 1940 (Kenneth Macksey’s Invasion: The Alternate History of the German Invasion of England, July 1940) or the failure of D-Day (Disaster at D-Day by Peter Tsouras).

In the same vein, what might an alternative response to the banking crisis have looked like? We need to know, because repeating the 2008 policy responses will not be an option when the next crisis happens.

In its early stages, the next crash is likely look a lot like the last one. It seems likeliest to start in China, where soaring debt has been invested in surplus capacity which has in turn driven profits sharply downward.

As with American sub-prime in 2007, the first impact will be the dawning realisation that many borrowers will be unable to keep on servicing their debts. This will lead to a seizing-up of credit markets, because participants cannot be sure which counter-parties are solvent and which are not. This will bankrupt institutions which have based their business model on recycling wholesale debt.

At the same time, the scale of exposure to bad debt – most notably in China – will gradually become clear. The backdrop will be a recognition that the economy is poised to turn down, making debt even harder to service.

In 2007, governments made clear their willingness to stand behind crippled banks, not just by guaranteeing deposits but also, where necessary, by taking banks into state ownership. But this will be far more difficult this time, mainly because governments are far more indebted this time around.

In 2007, the net-debt-to-GDP ratios of, for example, the United States, Britain, France and Japan were 44%, 38%, 57% and 80% respectively. Today they are 81%, 83%, 88% and 137%. Globally, the average government debt ratio is 83% today, compared with 63% in 2007.

This puts the rescue of banks into a wholly different context. In 2008, governments essentially reimbursed bank shareholders at something approximating to share prices, but the reality was that, in the absence of government support, these banks were worthless. It might have been better had governments recognised this, giving shareholders little or no compensation.

At the same time, banks were taken over as going concerns, which in most cases was exactly what they were not.

A better approach can be exemplified by looking at the British government’s rescue of RBS. Instead of taking over the existing corporate entity, the state could instead have set up a new company – say “RBS 2” – which could have shouldered the RBS assets and liabilities on a selective basis. The liabilities not taken on would have included the employment contracts and accrued pensions of senior executives, whose former employer would have ceased to exist.

The banks’ investment banking divisions could have been split out, and perhaps handed to the shareholders, being allowed to sink or swim at no further cost to the taxpayer. The longer-term aim would have been to turn the acquired banks into wholly retail operations, to be returned to private ownership when and if conditions allow.

More generally, the denial of government support would have resulted in widespread bank failures. With hindsight, allowing banks to fail – whilst protecting depositors – might have been a better response than propping up insolvent banks. Customer deposits and the branch network could have been taken into state ownership, to be returned to the private sector in due course in a far more sober form.

Monetary policy was, and remains, the really critical issue. As things stood, a failure to cut both policy and market interest rates would have resulted in extremely sharp falls in house prices, creating vast swathes of negative equity and seizing up property markets because millions of buyers, saddled with negative equity, would have been unable to sell.

Again, it might have been better to take this hit and let property prices slump, rather than distorting the entire monetary system (and penalizing savers). A bad debt – technically, a “non-performing” loan – is created when a borrower can no longer service the debt. Even if he can service it, however, a second problem exists where a property, bought using a $100,000 mortgage, becomes worth only $80,000.

Here, an alternative would be for ownership of the property – “ownership” which is purely notional, having no net value anyway – to be transferred to the lender, with mortgage interest payments converted into rent at a level that the customer can afford. The borrower is freed from negative equity, the market is not deluged with forced sales of properties, no one becomes homeless, the bank avoids write-downs (because debt is converted into equity) and property markets are reset at far lower levels.

What needs to be borne in mind here is that high property prices are bad for an economy, not good. Purely notional equity emboldens homeowners to taken on excessive credit, vast amounts of investment (which could otherwise be put to constructive use) are tied up in a useless capital sink, value is transferred between generations, and young people are put at a huge disadvantage.

What do we do now?

In short, an alternative response in 2008 would have been to let both banks and asset (including property) markets collapse. The state could have guaranteed customer deposits, and salvaged the banks’ purely utilitarian operations. The negative equity imposed on millions could have been erased by offering the option of converting from mortgage to rent.

It is hard to see how this could have cost more than what actually happened. The plus-side would have been that markets could reset without a resort to subverting the monetary system, penalizing savers and setting the scene for a renewed surge in borrowing.

When the next crash comes, governments will be forced to consider responses along these lines. Their existing debt levels will preclude taxpayer interventions on the 2008 model, and interest rates already at virtually zero cannot be cut further, whilst any further resort to QE could destroy faith in the monetary system.

It must be hoped that there is some preparedness, at least, for countering a very similar crisis in a very different way.

#57. Storm Front – part 2

THE CRISIS LOOMS – CHINA, CANUTE AND THE “WINDOW OF RISK”

In my previous article, I raised the possibility that China might be heading for a financial crisis, something which must – given the sheer scale both of the Chinese economy and of Chinese debt – pose a globally-systemic threat. Here, I take up the China story again, but also look into the global implications of what I think is happening.

I also set out some thoughts about the “when?” of all this. For a “non-Keynesian”, I am rather fond of quoting Keynes’ observation that “the market can remain irrational longer than you can remain solvent”. This I take as a warning against trying to predict the day when seemingly-obvious imbalances (like China’s debt) result in their logical consequences.

But Keynes also said that “in the long run, we’re all dead”, meaning that anyone who confines himself to long-range forecasting alone isn’t much help to anyone. So I’m going to describe what I call a “window of risk” – an impending conjuncture when, though things might not necessarily go horribly wrong, there is a meaningful likelihood that they will.

That window of risk opens next month.

First, though, China.

The waning of the “China syndrome”?

Markets, like almost any other human construct, are influenced by psychology. Human beings seem to have an addiction to extrapolation – if the price of something, or the scale of something, has been rising at 10% each year, we are prone to assume that it will go on doing so. Also, we don’t like admitting we were wrong.

Both of these tendencies incline people to think that the future will be a continuation of the recent past, which may be why so many seem reluctant to admit that China may go from boom to bust. This unwavering faith in Chinese economic invincibility is something that I call “the China syndrome”. Analysts can seem to be so dazzled by China’s past successes that they cannot see its current problems.

In fairness, anyone with a business presence in China has to be pretty careful about what they say, for China’s one-party state is very sensitive to anything negative. In fairness too, both governments and vested interests in the West have been known to “shoot the messenger”.

Looking through all of this, there does seem to be a gradual turning of sentiment on Chinese prospects. My basic thesis, as you know, is that China is heading for trouble because it is doing just what Britain, America and others were doing before 2008 – taking on debt in quantities that far exceed the scale of economic growth.

To remind you, China took on $15 trillion of “real economy” debt between 2007 and 2014, a period in which GDP expanded by $5 trillion, meaning that each dollar of “growth” was bought at a cost of $2.90 in new borrowings. (It also took on almost $6 trillion in financial sector debt).

This behaviour has two main consequences. First, and since all we’re really doing is spending borrowed money, it makes GDP look better than it really is, and thereby gives false comfort about the affordability of debt. Second, it creates investment excesses – a posh name for bubbles – as all that borrowed money flows either into inflating property markets (as in the West) or creating excess capacity (in China today).

We in the West have not, of course, learned from our past mistakes. In Britain, for example, the official line is that the economy will grow by a nominal £500bn over the coming five years, but only if debt grows by close to £1,000bn (including a rather scary £330bn of extra unsecured household credit, plus £500bn pumped into further inflating the housing market).

Still, I believe that the scales may be falling from collective eyes about China, and that the trickle of cautionary sentiment may be poised to turn into a flood.

If this is the case, China won’t be alone. Brazil is mired in huge problems, whilst the Russian economy has clearly fallen victim to a combination of weak oil prices and Vladimir Putin. India looks robust enough for the present, but, India aside, the much-vaunted “BRICs” – which, if you remember, were supposed to be the new drivers of the global economy – seem to be turning into BRIC-dust.

Angst behind The Wall

In China, though, the greater problem of the two isn’t the property market but excess investment in capacity, which includes commercial and industrial real estate. Much of this investment is carried on by local government development vehicles, and here’s a telling statistic for you – these vehicles are now earning an average return on assets of 2%, but they are paying an average of 6% interest on their debts. Unchecked, that can lead in only one direction.

I have long suspected that China might have been planning to convert much of this debt into cheaper and less risky equity by floating these entities on a booming stock market. If that was indeed the plan, it has surely blown a fuse with the recent downturn in the Chinese market, which is now 23% below its June peak (and would no doubt have fallen even further but for the kind of market manipulation which never works in the long-term).

This also helps explain recent successive devaluations of the RMB, since one possible solution to excess capacity is to make your goods and services cheaper to foreigners by devaluing. Here, China seems to be joining a “race to the bottom” in forex markets, particularly in Asia, where I have long believed that Japan’s “Abenomics” policy (which I have called “kamikaze economics”) has currency war implications.

Increasingly, meanwhile, we are witnessing growing scepticism about official Chinese stats, a scepticism reinforced by growth having hit, precisely, the official target of 7%. If China is indeed growing at 7%, this is very hard to reconcile with “physical” metrics – unit sales of vehicles, for example, are trending down, as is Chinese factory output – or with a raft of sales and profit warnings from multinationals who say that their businesses in China are set to deliver lower numbers.

The big pressure, then, is likely to occur in areas of excess capacity, where returns are far lower than the cost of servicing debt.

This could push vast swathes of debt under water, on a scale that will almost certainly dwarf subprime loss exposure in the US immediately before the banking crisis.

But this does not mean that Chinese households are immune from consequences. Though Chinese mortgages require sizeable (say 30%) deposits, there is such a thing as borrowing your deposit. Chinese people who have invested in property or the stock market as a form of saving for old age seem certain to be in for some very nasty shocks. This in itself must worry the ruling Party, since its authority rests on a “grand bargain”, in which people surrender their liberties in return for the guarantee of prosperity.

The bigger picture

In any case, China is by no means alone in facing a nasty financial reckoning. Globally, the authorities responded to a mountain of debt through a policy of ultra-cheap money, preferring to make debt more “affordable” rather than face the tougher option of wholesale write-offs. My interpretation has long been that, when cutting “policy” interest rates proved to be insufficient, central banks turned to QE in order to inflate bond markets, thereby driving market interest rates – yields – downwards.

This was never going to be anything more than a medium-term, “extend and pretend” fix. It has also had a series of side effects, including excessive borrowing (because debt is cheap) and the probable debasing of the value of money (something that we have discussed here before).

As things stand, this particular chicken now seems to be coming home to roost. The initial warning flag (if I may mix my metaphors) is now showing in the US bond market, where liquidity seems to be drying up. For the non-technical, this means that selling a sizeable block of bonds is now becoming difficult, as an absence of buyers pushes the price down whenever a large sell order is placed. Some analysts are now talking about a bond market “bubble” (which makes one wonder where they have been for the last three or more years).

The world outside China has seen a welcome restraint in purely financial sector debt since 2008 – ex-China, this debt increased by only $3 trillion since 2007, compared with a leap of $16 trillion between 2000 and 2007 – but, this aside, “real economy” debt has continued to grow by leaps and bounds. In the world outside China, this debt has increased by $34 trillion, or $3 for each dollar of nominal GDP growth (of $11 trillion) over the same period.

We seem, then, to have learned little or nothing since the 2008 crisis. Whether in China or elsewhere, we’re continuing to deliver delusory “growth” by borrowing vast amounts, in the ratio of roughly 3:1 of borrowing-to-growth. We are trying to operate a capitalist system without returns on capital, which is a logical nonsense, and we are still measuring the affordability of debt by the faulty metric of GDP inflated by borrowing. We are still inflating our property markets, too, and still drawing false comfort from asset markets that we have inflated ourselves by borrowing money, much of it created for that purpose.

Mixed metaphors and the “window of risk”

Thus far we have had roosting chickens, scales falling from eyes, bubbles and warning flags, and now – to add to our basket of metaphors – we have growing evidence that “the light at the end of the tunnel” is in fact a train heading towards us.

My final metaphor is a “window of risk”, which I believe will open in September. That is when everything may impact – draining bond market liquidity, recognition of a “bond market bubble” and, of course, the possible crunch-point in China. Who knows, we may even have a Fed interest rate increase to contend with (though that I rather doubt).

I never for a moment underestimate the ability of the authorities to buy time, which is why I refer to a “window of risk” rather than making a more concrete forecast. But the cost of buying time keeps rising, and the money that the authorities are spending to buy it keeps losing its credibility.

Come back, Canute – your modern successors have forgotten your lesson.

#56. Storm Front – part 1

WHY THE NEXT CRISIS WILL START IN CHINA

Though the recent slump in the Chinese equity market should be seen within a limited context, there is a strong and growing likelihood of a major financial crash starting in China before spreading globally.

Since 2007, China has acted like America before the crisis, borrowing $3.90 for each $1 of reported growth. Spending borrowed money, and treating this as “growth”, was a hallmark of the most at-risk economies before the 2008 crash. So, too, were the wasteful use of borrowed funds, and the proliferation of “shadow banking”, both of which now characterise China.

That these risks are being widely underrated by global markets is evidence of immense complacency. In the eyes of many, mesmerised by the country’s past successes, China can do no wrong. This complacency is a “China syndrome”, similar in nature to the “Japan syndrome” of the 1980s. How often do we read that China’s economy is “unstoppable”? How often was that said about Japan in the 1980s?

The Chinese economic transition – from huge exporter to more balanced consumer – is clearly going badly wrong. Debt-addicted China looks increasingly like subprime-hobbled America on the brink of the crisis.

Introduction

Welcome to the first part of “Storm Front”. We’ve covered a lot of ground on this site, but now I want to address a really critical issue – are we heading for a new financial crisis?

I’m convinced that we are. I have never believed that the 2008 banking crash was a complete, “done-and-dusted” event, and nothing that’s happened since has changed this view.

After all, the 2008 crisis happened because we had been borrowing $3.20 for each dollar of growth in the economy. Since then, this has actually worsened, with each dollar of growth now coming at a cost of $3.40 in borrowed money. Globally, debt increased by $55 trillion between 2000 and 2007. Since 2007, debt has grown by a further $57 trillion.

In fact, if we look at what is known as “real economy” debt – which excludes the banking sector – things are much worse now than before the crash. Prior to the 2008 crash, we had taken on new debt of $38 trillion – or $2.20 for each dollar of “growth” – over a seven-year period. Over the subsequent seven years, that number has increased to $49 trillion, or $2.90 for each “growth” dollar.

From this, you might conclude that we seem incapable of learning from our past mistakes. You would be right, but would need to take into account, too, that global responses to the first (2008) crisis hard-wired the next crash into the system.

As well as huge debts that could never be repaid, the authorities became aware in 2008 that simply trying to keep up the payments on this mountain of debt could, of itself, bring down the system. When cutting “policy” interest rates proved to be insufficient, central banks set out to manipulate market interest rates – bond market yields – as well. This was what the creation of money through “quantitative easing” (QE) was really all about.

To understand where things are going, we need to pose three questions:

1. Why does an event like the 2008 crash happen?

2. Are the conditions in place for a re-run of the financial crisis?

3. Where is the next crunch likely to start?

For those who like to cut to the chase, here are some quick answers.

First, a banking crisis occurs when the system has created more debt than it can cope with.

Second, the pre-conditions for a crash are in place now – this need not mean that a crisis is imminent, but it does surely mean that a crash is extremely likely. The relevant questions now are “when?” and “where?”, and perhaps “how?” – but not “if”.

Third, the likeliest start-point for the next crash is China (a view that is not, by the way, particularly influenced by recent turbulence in the Chinese stock market).

1. Why does an event like the 2008 crash happen?

A multiplicity of causes can be cited for the 2007-08 banking crash, and many of them played some part in what happened. What we need, though, is one key lead-indicator, a single metric that can warn that a financial storm front is looming.

That indicator is an unsustainably rapid increase in indebtedness, measured in relation to economic output. More specifically, it is an excess of private borrowing. Why private (rather than state) debt is the problem is explained later.

Of course, the fact that an increase in debt is a pre-condition for a crisis pretty much goes without saying. Between 2000 and 2007, global debt increased by 63%, from $87 trillion to $142 trillion. In the seven years in which this $55 trillion increase in debt was taking place, the nominal value of the world economy increased by just $17 trillion, meaning that each $1 of growth was purchased using $3.20 of new debt.

This ratio was far worse in some countries (such as America, Britain and, most obviously, Iceland and Ireland), and far more restrained in others. But the overall relationship between debt and growth was inherently unstable.

GDP – the general measure of economic output – can be calculated in three main ways. Two of these are income, and gross value added, but the one to focus on here is consumption. Now, if your annual expenditure increased by $17,000, either because you had added $17,000 to value being created in the economy, or because your salary had increased by that amount, that would be one thing. But if your annual expenditure increased by $17,000, but only because you had taken on $55,000 of new debt, that would not amount to an increase in your prosperity. You would simply have mortgaged the future in order to increase your spending today. This would not be a sustainable state of affairs.

In short, expanding GDP simply by spending the proceeds of borrowing is not really “growth” at all. In the pre-2008 years, growth in Britain and America amounted to nothing more than the recycling of borrowed money.

We can be more specific by dividing debt into three categories. The first of these is financial debt, which is the scale of indebtedness between banks and other financial institutions. This accounted for $17 trillion within the $55 trillion increase in global debt between 2000 and 2007.

If we exclude this banking component, what remains is “real economy” or “non-financial” debt. This increased by $38 trillion – from $67 trillion to $105 trillion – in the seven years before the crash. Therefore, each $1 of growth had come at a cost of $2.20 of new “real economy” debt. Again, this number was far higher in countries like Britain and America than in other, more conservative economies. This virtually ensured that a crash, when it came, would occur in one of a limited number of countries.

To qualify as the host venue for a crisis, a country had to meet two criteria.

First, its economy had to be big enough to matter – a crash in a country like Iceland, Ireland, Dubai or Greece would not have been of a magnitude sufficient to undermine the global financial system.

Second, it had to happen in a country where debt had got out of control, and where a boom had taken place on the basis of borrowing.

So the crash virtually had to happen in one of the few countries which were both large enough to matter and reckless enough to hit problems. It could have started in Britain, but it was always likeliest to occur in America, which, of course, was exactly what happened.

“Real economy” debt in turn divides into two categories – state and private. In the 2000-07 period, private and government borrowing contributed $26 trillion and $12 trillion, respectively, to the $38 trillion increase in debt. Geographically, however, there was a starker division, with the private sector accounting for almost all of the debt escalation in countries like Britain and America, where government indebtedness did not increase.

Logically, economies in which private indebtedness is escalating should also be countries where state debt is not under upwards pressure. For a start, an economic boom – even if borrowed, and thus essentially phoney – should, while it lasts, boost tax revenue. Second, the boom should likewise reduce the cost of welfare to government.

The second reason why private rather than state debt flags an impending bust is that excessive private borrowing can be wasteful. Of course, government borrowing can be wasteful too, but it is unlikely to be exposed as such. If, say, the British authorities were to spend too much on hospitals, or schools, or defence, this might be wasteful, but, being in the state sector, it is unlikely to be subjected to financial exposure.

This is where private borrowing is different. Excessive borrowing by the private sector almost certainly means wasteful over-investment. It might amount to pouring too much borrowed money into the housing market, which was what happened in America and Britain.

Alternatively, it might take the form of wasteful investment in capacity of one form or another.

Either way, it is a hostage to exposure.

In Britain, the US and elsewhere, wasteful investment in property markets was exposed when servicing the debt became impossible. This had to result in massive bad debts resulting from property market losses, which is exactly what happened until it was stemmed – probably only temporarily – by governments (a) bailing out the banks, and (b) adopting policies of interest rate reduction and the rigging of market yields. This, of course – and as the Bank for International Settlements noted in a recent report – carries risks of its own.

The other way in which an excess of private borrowing can result in huge losses is where funds are invested in unnecessary capacity. Where this happens, the excess capacity – be it in factories, offices or real estate – will drive returns downwards, making much of the associated debt non-viable.

2. Are the conditions in place for a re-run of the financial crisis?

As we have seen, the financial crash of 2008 resulted from an excess of debt. Looking only at real economy borrowing, global debt increased by $38 trillion during a seven-year period in which nominal GDP increased by just $17 trillion. This meant that each dollar of “growth” had come at a cost of $2.20 in new debt.

In the seven years since the crisis, and far from improving, this ratio has become even worse, with nominal “growth” (again, $17 trillion) happening on the back of $49 trillion of new debt. So the ratio of new debt to each dollar of growth has worsened, to $2.90 from $2.20.

There are several reasons why this has happened. First, central bank policy responses to the 2008 crash have made borrowing much cheaper. Globally, the authorities opted for cheap money as the only – or, at least, the most painless and politically acceptable – response to the mountain of debt that had crippled the system. As we have seen, they accomplished this partly by reducing official rates to zero, but mainly by manipulating capital markets using vast sums of money newly created for the purpose.

This may well have debauched the monetary system as well – indeed, it probably has – but what matters here is that it has resulted in debt growing even more rapidly than in the years before the 2008 crisis.

Second, the world seems to have become incapable of delivering growth by any means other than borrowing. Britain has done better than most at solving this conundrum, reporting growth in real GDP whilst moderating (though not reversing) the accumulation of debt. Even in Britain, however, all is not what it seems. A big chunk of Britain’s growth is attributable to vast sums of compensation paid out by the banks. Even more has been funded by a chronic current account deficit, which last year resulted in the United Kingdom borrowing almost £100bn from foreign lenders, quite aside from being a huge net seller of assets. Borrowing has shifted from the private sector to the British state, and movements within private debt suggest that the emphasis has shifted from investment to consumption, which is precisely the reverse of what the authorities have been trying to accomplish.

3. Where is the next crunch likely to start?

Any objective analysis of the situation must identify China as by far the likeliest venue for the next financial crash. Of the $49 trillion in new real economy debt taken on globally since 2007, $15 trillion – 31% – has been added in China. This amounts to $2.90 of new debt for each $1 increase in nominal GDP over that period. These numbers, by the way, are calculated on a PPP (purchasing power parity) basis, so are not distorted by the official Chinese exchange rate.

There are other ways in which China since 2007 has echoed, in an almost uncanny way, what happened in the US and elsewhere in the years preceding the crisis.

For a start, much of the increase in debt has been associated with real estate, which now accounts for almost half of China’s total debt.

Second, the “shadow banking” sector – critical in creating huge loss exposure in the US and elsewhere before the crisis – has been growing like topsy in China, expanding at an annual compound rate of 36% since 2007.

Third, much of the expansion in debt has been in the private (or quasi-private) sector, which, again, is what happened in the West before 2008. Government debt remains pretty low, but the same could be said of America, Britain, Spain and many other economies before the crisis.

What history teaches us is that state debt ratios tend to expand dramatically after a crisis has taken place, when the government has to assume responsibility for a lot of private, quasi-private or financial sector “toxic assets”.

Of course, some optimistic believers in the ”China syndrome” of irreversible success argue that China’s low state debt ratio will enable Beijing to engineer a soft landing – increasing the state debt ratio to, say, 80% might not be unreasonable, and this would enable China to take on, say, $3 trillion or more of at-risk debt. Those who draw comfort from this observation seem to underestimate the sheer difficulty that China would encounter in trying to raise this kind of money. Likewise, those who believe that China’s huge reserves can be used to fill the gap seem to forget that deploying this would involve selling vast quantities of un-repayable American IOUs to replace equally un-repayable Chinese commercial debt.

One analyst has put Chinese exposure to bad debts in the region $2-3 trillion which, if correct (and it probably is) would inevitably trigger a crisis in which even perfectly viable borrowers could be brought down by the failure of those by whom they, in turn, are owed money.

The indications are that loss exposure in Chinese property already far exceeds the exposure in US sub-prime that triggered the crash in 2008.

Finally, we need to look at what the sheer quantum of Chinese borrowing tells us about the economy. Chinese GDP continues to grow at impressive rates, but indications are mounting that all is not as it seems.

For a start, and like America, Britain and others in the recent past, increments to Chinese GDP are far exceeded by additional borrowing.

Second, an increasing number of multinational corporates are warning of deteriorating volumes in the Chinese market, whilst factory activity is shrinking.

Most important of all, there is increasing evidence that the excess of private borrowing is being reflected in surplus capacity, which is precisely what one would expect given the link between excessive borrowing and wasteful investment. As well as inflating its property market, China seems to have built industrial, retail, housing and office capacity far in excess of realistic demand. We should never forget that GDP includes additions to capacity – but GDP simply records these additions, without warranting their future viability.

As remarked earlier, the gyrations of Chinese stock markets may not be particularly important, but they are very significant in one way that often fails to attract comment – essentially, China’s attempt to convert vast swathes of debt into less systemically-risky equity has undoubtedly blown a fuse.