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.