#57. Storm Front – part 2


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.

15 thoughts on “#57. Storm Front – part 2

  1. It does seem that there is a general air of pessimism growing about the global economy and the ability for governments to prop up markets, even within the mainstream media. The only thing that keeps the game going at the end of the day, is confidence. When confidence is lost and the major players head for the door, that will be that. Could this happen when the Fed inevitably back tracks on their commitment to raise rates this year? Perhaps.

    Regarding China, they are an interesting conundrum. I’ve been wondering about their long term strategy and I think they will come out of this holding all the cards. We all know that the world’s governments are now killing their fiat currencies at ever increasing speed, and it seems logical that some are looking towards what happens after the inevitable death of these currencies. This could be the reason why central banks are increasing their gold purchases and in some cases, repatriating their gold stores from foreign nations. China has grown it’s debt more than any other nation, but look at what they’ve achieved alongside this debt:

    1. Become the world’s manufacturing powerhouse, with factories, infrastructure and heavy industry to support the world’s economy
    2. Built cities, airports, power grids and other infrastructure and to house and support it’s growing middle class
    3. Made bilateral trade agreements with many other nations, created financial institutions (such as the BRICs bank, SCO, SGE, and more) to rival those of the west, as well as a new global payments system to compete with SWIFT
    4. Double-digit percentages in military spending for the past 20 years, creating a modern military force to rival any in the world
    5. HUGE increases in gold imports for decades, as well as keeping all of their own mine production. True reserves of the PBOC remain a mystery but some estimates range in the 10,000s of tonnes, and this doesn’t include the private gold holdings in the rest of China

    Now, if the world’s fiat currencies hyper inflate, the fiat denominated debts go to zero and the only thing left is the real assets you hold. From China’s perspective, when the music stops their position would look pretty damn good, not too dissimilar to the US at the end of WW2. All they have to do is survive the coming deflation of financial assets and death of fiat, no mean feat but that huge pile of gold will help with this regard. Could this have been their plan all along?

    • Rich

      A fascinating thesis and, as I think it’s your first here, welcome aboard.

      Your first points accord with my view. You are right about confidence, and right about this being at risk. Later this year certainly is my “feel” for where this is going. To me, the situation seems ominous, and what I’ve been trying to do here is to get at the “why” of this.

      Where China is concerned, I’ve long assumed some strategic intent behind what they are doing. The hold enough dollars which, if sold, could crush the value of the USD. Though the PLA (army) is a political icon in China, the emphasis today is on the Navy (the PLAN) rather than the Army, and they are making solid progress, notably with submarines and carrier aviation. Their investments, most notably in Africa, seem designed to wrest control of resources from the West. Thus far this does seem strategic – even though China itself might say that these moves are nothing more than appropriate in terms of matching their political and military scale to their existing economic importance.

      But planning for the day when fiat currencies implode seems quite a stretch. After all, the RMB is a fiat currency. I don’t doubt that the fiats are increasingly at risk, but I’m surprised that gold prices aren’t a great deal higher. Gold bugs have been saying for years that global supply, purchasing and stock numbers don’t add up, and some say that the US can’t return stocks to their owners – most notably Germany – because the US doesn’t actually have the gold that it’s supposed to have.

      What I struggle with is the transition – for instance, keeping order in a society that’s had its savings wiped out. This said, I think it’s an issue that governments may be planning for, or, if they’re not, then they should be.

    • The only thing I’d add is that China has a long history with fiat and I believe they are very aware of this history. Whether that has played into their strategic planning I suppose we will have to see. But I do agree, how can one realistically plan for financial catastrophe? Perhaps this is why they accumulate gold, so that before catastrophe hits they can restore confidence, via gold-backing maybe.

      Regarding the gold price, it is natural that the gold price, which is set in the US futures market, remains detached from physical demand, especially in times of crisis. Gold after all is the main competition for the reserve fiat currency, and a significant rise in the gold price communicates to the market that trust and confidence in fiat is waning, which could trigger a run on the currency. We saw this in 2008, when despite a huge rise in physical demand for gold and silver (and indeed some mints running dry and placing customers on back-order for weeks at a time), the futures price for these metals dropped!! Yet, the premiums for physical rose so despite the official price, you simply couldn’t buy any metal at that price. What this means is that the futures gold price is a manipulated metric and can not be relied upon to communicate the rise in risk to the financial system.

      Anyways I enjoy your posts, many thanks for the efforts and keep them coming!

    • Rich

      Let me start by recommending an article today by David Stockman – http://www.davidstockmanscontracorner.com. I recommend this, first because, like many others, I rate him, but mainly because of what he says today – that China’s rulers have never understood markets and have been building a giant ponzi scheme right from Day One.

      About gold, what I really meant (but phrased very badly) was that physical movements in gold – where it’s come from, gone to, and is supposed to be right now – is said by experts not to add up. Pricing is …..well, perhaps they don’t call the daily price “the London fix” for nothing.

      Governments have always cast a wary eye at gold as a potential rival to the “seignuerage” monopoly on which faits rely. That’s why they fear any succesful alternative, such as Bitcoin. Let’s not forget that FDR actually nationalised gold – in the free enterprise US! – in 1933, with stiff penalties for anyone hiding the stuff. He paid compensation of $21/oz, then later let people buy it back for $28.

    • Big fan of David Stockman (I have a copy of The Great Deformation on my bookshelf at home waiting for it’s turn to be read), and for the most part I agree with him. But we can’t escape the reality that after a “financial” collapse, China will still have gained more “real stuff” that the west gained for all their debt accumulation, which we have squandered on consumption rather than investment. The big question is whether this was planned or by accident, and Mr Stockman would argue the latter. It doesn’t explain why China is selling treasuries and buying gold in such extreme amounts though…

    • I believe governments are preparing for it. Boris and his water canon was a small step in that direction and earlier this year the US army/national guard undertook exercises preparing for mass civil unrest:
      Governments got away with bail ins in Cyprus, and are trying again in Greece and Austria (albeit that senior judiciary has stated it unconstitutional in the case of the latter. Governments are planning bail ins to bail themselves out, and would ideally like to turn society cashless overnight (after all it’s hard to have a bank run if liquid tender no longer exists). When people like Krugman and Buiter start attesting to cash having had its day you know you’re in trouble. With this kind of policy thinking in the wings civil unrest is a certainty.
      Personally I see gold as a hedge against government collapse, so I think it has a role in the mix, but not yet. We need to see bond liquidity plummet (I agree Q3/4 this year) and then the thing will truly unravel and central banks (which in my view have already lost control) will be the Emperor’s New Suit of clothes.
      On the China issue, I believe that despite their current malaise, we will see the global fulcrum move East faster and faster. China has made some very shrewd decisions (investment in Africa/African resources being one) and US hegemony is waning with all the signs of a dying empire. My concern is that rather than go quietly it may decide to take the world down with it. Certainly if its foreign policy of the past 10 years is anything to go by then we are in deep trouble. Of course war is the age old way of resetting the dial so this may not be unrelated.
      And to think that what we really need is co-ordinated debt forgiveness and for the state to resize itself to a few core functions (a view)……

  2. I think there is plenty of evidence that the US has been preparing for mass outbreaks of civil disobedience: – the militarisation of their Police Forces, FEMA camps, stories of stock-piling of ammunition, Jade Helm and the raft of contingency protocols that have been drafted (if not already enacted) as a contingency for sovereign default.

    I’m not sure the UK will be similarly equipped, although reading between the lines of the Civil Contingencies Act (CCA) the entire UK could remain under martial law until a food surplus is achieved and central reserves can grow once again. If our reserves are totally depleted before the next cycle of growth is established, society will break down altogether.

    • Interesting thoughts. The governing elite always equates the status quo with “the national interest”, and the US always seems to me to take this to extremes – America still uses the death penalty (which frankly I oppose), and dishes out multi-hundred-year prison sentences, which seems to me more macho than rational.

      Britain seems to assume that the state, the courts and the police are somehow sacrosanct and infallible, an absurd position for a country guilty of flogging prisoners, Captain Bligh-style, into the 1960s, and subjecting Alan Turing to chemical castration. In many ways the UK remains a bit daft in this respect. It seems to obsess over “contrition”, which in fact doesn’t change the crime. I often hear that “if you’ve done nothing wrong, you’ve nothing to fear” – which is fatuous in the extreme – whilst media and public alike sometimes seem to want all Home Secretaries to respond in extreme ways to virtually any issue.

      States are likely to gear up when there are perceptions of a potential crisis. I do suspect, though, that this might be happening anyway, because the power of the state has been increasing, and the liberties of the individual have been in retreat, for many years now, a function – I believe – of the rise of corporatism.

      Overlaying this is the risk of terrorism – ISIL in particular is a threat that would be hard to overstate, though I don’t recall a similar curtailment of liberties and spread of surveillance during the IRA terror campaign.

    • Another good point. My MP is Theresa May. I have written to her endlessly to say that her “snooper’s charter” is unwarranted intervention into private affairs and that during the IRA campaign we “took our chances”. Of course one has to ask whether such legislation is really about extremism or is just about state surveillance. As you say we’re like the proverbial frogs in cold water – by the time it’s boiling it will be too late to jump out of the pan.

  3. Hi Dr Morgan

    I’m new to your blog but have read your papers for Tullet Prebon and find them very good, very convincing and contrarian – a very good antidote to the cheerleaders at the MSM who I read less and less.

    I see Rich Browne’s comment and can see what he’s getting at but it’s high risk to say the least.

    The Chinese now have an elite and a middle class that is wealthy but is denied political power and a mass which has been brought from the country with ideas of improvement in living standards. The sort of scenario mentioned above – where China would be the last man standing as it were – is, to my mind extremely high risk to say the least. I believe there have already been riots in some parts of China due to the deteriorating economic situation and the wealthy elite must be less than chuffed at the drop in the Shanghai Composite.

    Also the Chinese do have to address the demographic issues due to the one child policy which is already impacting on the economy.

    I agree that the situation in China is pivotal to our own but I have doubts that there is a grand plan at the back of all this.

    • My view here is that the vast majority of political leaders’ thinking runs in tram-lines. Most conservative politicians think that little can be accomplished by the state, and most socialists think nothing good comes of handing things over to private enterprise. Both, of course, are wrong – what works best is a “horses for courses” mixed economy.

      Ultimately, the Chinese bosses are communists. Their handling of the stock market corretion reminds us of this – their instinctive reaction is to “command” the market not to fall. A Western response might be to cut interest rates. A Chinese reaction is to order people not to sell, or even to talk the market down. Both are wrong – a stock market is best left to itself.

      So, where a Western leader might ask “will this new investment make a profit?”, their thinking is along the lines of “is it good for us to have a new railway, housing development, factory, etc?”, generally concluding that expansion (of capacity) is synonymous with growth.

      This suggests that they think in terms of scale, just as Western leaders think in terms of profit.

      We have a habit of venerating foreign leaders who seem to get things right, and to credit them with extraordinary vision and competence. We did this with Japan, whose economic “miracle” was actually pretty straightforward. I think we’re in danger of doing this now with China.

      China’s leaders are clever men, but they are men – not Superman.

  4. Pingback: #58. Storm Front – part 3 | surplusenergyeconomics

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