#152: Stuffed

WHY THE MONETARY LIFEBOAT WON’T FLOAT

The global financial system has come to rest on a single complacent assumption, one which is seldom put explicitly into words, but is remarkably implicit in actions.

This assumption is that the authorities have, and are willing to deploy, a monetary ‘fix’ for all ills.

Accordingly, the system has come to be seen as a bizarre casino, in which winning punters keep their gains, but losers are sure that they’ll be reimbursed at the exit-door.

So ingrained has this assumption become that it’s almost heresy to denounce it for the falsity that it is.

The theme of this discussion is simply stated. It is that the complacent assumption of a monetary fix is misplaced. The authorities, faced with a crash, might very well try something along these lines, and might even adopt one or more of its most outlandish variants.

But it won’t work.

The reason why no monetary expedient can provide a “get out of gaol free” card is that the economy and the financial system are quite different things.

The complacent rush in  

You can see financial manifestations of mistaken complacency wherever you look.

It emboldens those who have lent most of the $2.9 trillion that, over the last five years, American companies have ploughed into the insane elimination of flexible equity in favour of inflexible debt.

It informs those who pile into the shares of cash-burners, or queue up to buy into overpriced IPOs.

It reassures those long of JPY, despite the monetization of more than half of all outstanding JGBs by the BoJ.

It tranquilizes those who, unable to see the contradiction between gigantic financial exposure and a stumbling economy, remain long of GBP.

It blinds those to whom the Chinese economic narrative remains a miracle, not a credit-fueled bubble.

The aim here is a simple one. It is to counter this complacency by explaining why economic problems cannot be solved with monetary tools, and to warn that efforts to do so risk, instead, the undermining of the credibility of currencies.

A casino which hands back losers’ money belongs in the realm of pure myth.

The secondary status of money

Money has no intrinsic worth. Someone adrift in a lifeboat in mid-Atlantic, or stranded in the Sahara, would benefit from an air-drop of food or water, but even a gigantic amount of money descending on a parachute would do nothing more than allowing him or her to die rich.

Conventionally, money has three roles, but only one of these is relevant. Fiat money has been an atrociously bad ‘store of value’, and money is a very flawed ‘unit of account’. Money’s only relevant role is as a ‘medium of exchange’.

For this to work, there has to be something for which money can be exchanged.

This means that money has no intrinsic worth, but commands value only as a claim on the products of the economy. If you build up a structure of claims that the economy cannot honour, then that structure must – eventually, and in one way or another – collapse.

Conceptually, it’s useful to think in terms of ‘two economies’. One of these is the ‘real’ economy of goods and services, its operation characterised by the use of labour and resources, but its performance ultimately driven by energy.

The other is the ‘financial’ economy of money and credit, a parallel or shadow of the ‘real’ economy, useful for managing the real economy, but wholly lacking in stand-alone substance.

To be sure, the early monetarists oversimplified things with the assertion that inflation could be explained in wholly quantitative monetary terms. The price interface between money and the real economy isn’t determined by the simple division of the quantity of economic goods into the quantity of money.

Rather, it’s the movement or use of money that matters. The quantitative recklessness of Weimar would not have triggered hyperinflation had the excess been locked up in a vault, or in some other way not put to use. It’s not hair-splitting, but an important distinction, that Weimar’s true downfall was not that excess money was created, but that it was created and spent.

The process of exchange, which really defines the role of money, makes the interface dynamic, and, as such, introduces behavioural considerations. The creation of very large amounts of new money needn’t destabilize the price equilibrium if people hoard it, but a lesser increment can be extremely destabilizing if is spent with exceptional rapidity. This is why the simple quantitative interpretation needs to be modified by the inclusion of velocity, making Q x V a much more useful monetary determinant.

Behaviourally, velocity falls when people turn cautious – they did this during and after the 2008 global financial crisis (GFC), a tendency which reduced the inflationary risk of the loose money responses deployed at that time.

Even so, claims that the monetary adventurism unleashed at that time did not trigger inflation are simply untrue, unless you accept a narrow definition of inflation. To be sure, retail prices haven’t surged since 2008, but asset prices most certainly have, the truism being that the inflationary effects of the injection of money turn up at the point at which the money is injected.

Additionally, inflation is influenced by expectations – which have been low in an era of ’austerity’ – and by the performance of the economy. An economy which is performing weakly puts downwards pressure on inflation.

What it does not do, though, is to eliminate latent inflation. Any erosion of faith in the reliability of money would cause velocity to spike, as people rush out to spend it whilst it still has value.

Fiat fallacy

One of the analytically adverse side-effects of monetary manipulation is that it inflates apparent activity. Globally, and expressed in constant 2018 PPP dollars, the $34tn increase in recorded GDP since 2008 cannot be unrelated to the $110tn escalation in debt over the same period. According to SEEDS, most (67%) of the “growth” recorded over that period was nothing more than the simple effect of spending borrowed money.

This matters, first because a cessation in credit injection would undermine supposed rates of “growth” and, second, because a reversal would put much prior “growth” into reverse.

By falsifying GDP, this ‘credit effect’ also falsifies any relationships based on it – so the ‘comfortable’ 218% global ratio of debt-to-GDP masks a real ratio which is nearer to 340%, and higher by more than 100% than it was ten years ago (236%). It also distorts the measurement of financial exposure, so lulling us into misplaced insouciance about those countries (such as Ireland and Britain) whose financial assets stand at huge multiples to the real value of their economies.

Behind the mask of ‘the credit effect’, global economic performance is at best lacklustre, growing at about 0-9-1.3% annually whilst population numbers are growing by 1.0%.

Moreover, these numbers disguise regional disparities – whilst the average Chinese or Indian citizen continues to become more prosperous (for now, anyway), the average Westerner has been getting poorer for at least a decade.

Of course, there’s a countervailing ‘wealth effect’, giving false comfort to those whose assets have soared in price – and few, if any, of them appear to wonder what would happen if there was a rush to monetize inflated values.

But the drastic distortion in the relationship between asset values and incomes has real downsides exceeding its (illusory anyway) upside. Policymakers and their advisers may remain ignorant of the deterioration in Western prosperity, but to voters it is all too real, something which has been a major contributor to those changes in voter responses which have informed “Brexit”, Mr Trump’s ascent to the White House, and the rolling repudiation of established political parties across much of Europe.

The decline of “stuff”

The weakness of the underlying picture has now started showing up unmistakeably in weakening in demand for everything from cars, domestic appliances and smartphones to chips and drive-motors. Logically, deterioration in the economy of “stuff” will extend next into commodities because, if you’re making less “stuff”, you need less minerals, less plastics and, critically, less energy with which to make it.

Whilst all of this is going on in plain view, markets and policymakers alike are failing to recognize the risks implicit in the widening gap between a stumbling economy and escalating financial exposure. As well as borrowing an additional $110tn since 2008, we’ve blown a not-dissimilar-sized hole in pension provision, because the same low cost of capital which has incentivized borrowing has also crippled the rates of return on which pension accrual depends.

Additionally, of course, the prices of equities and property have reached heights from which any descent into rationality would have devastating direct and collateral consequences.

When the next crisis (GFC II) shows up, the complacent expectation is that everything can be ‘fixed’ with even looser monetary policy. Some of the more bizarre suggestions aired in 2008 – including ‘helicopter money’, and NIRP (negative interest rate policy, with its implicit need to outlaw cash) – will doubtless come to the fore again, accompanied by a whole crop of new ‘innovations’. The authorities are likely, in the stark despair which follows protracted denial, to act on at least some of these follies.

The trouble is that it won’t work.

You might as well try to rescue an ailing pot-plant with a spanner as try to revive an ailing economy with monetary innovation.

The form that failure takes need not necessarily involve massive inflation, though this is the only non-default route down from the debt mountain. Authorities capable of believing that EVs are “zero emissions”, or that we can overcome the environmental challenge with some form of “sustainable growth” (rather than degrowth), are perfectly capable of also believing that we can fix economic problems with monetary recklessness.

If inflation doesn’t spoil the party, two other factors might. One is credit exhaustion, in which massively indebted borrowers refuse to take on yet more debt, irrespective of how cheap the offer may be.

The other factor might well be a loss of faith in money, which might also be accompanied by a ‘flight to quality’, perhaps favouring the dollar (as ‘the prettiest horse in the knackers’ yard’), whilst hanging weaker currencies out to dry.

However it pans out, though, we know that an economy whose prosperity is faltering cannot indefinitely sustain an ever-growing burden of financial promises. By definition, whatever is unsustainable eventually fails, and this is as true of monetary systems as of anything else.

#151: The Great (brick) Wall of China

HOW SERIOUS IS THE CHINESE DOWNTURN?

For more than ten years, capital markets have had one perennial obsession, with Wall Street, in particular, rising or falling with the latest change of sentiment over Fed rate policy. Now, though, a new fixation has taken over, with stock markets reacting to every slightest positive or adverse nuance in trade talks between China and the United States.

These obsessions share an irony, which is that the outcome of neither has ever been in much doubt.

On rate policy, and even when Fed comments have been at their most bullish, there’s never been much real chance of rates rising back towards what, pre-2008, was considered “normal”. After a ten-year-long debt binge, followed by more than a decade of ultra-loose monetary policy, the American and world economies are locked into an abnormality which must continue until it reaches its culminating failure.

Pushing rates up to, say, 250bps above inflation would crash the economy, and everybody knows it. At each and every downturn in sentiment and performance, central banks are going to reach for the taps, until either credit exhaustion, and/or the loss of faith in money, puts the experiment of ‘financial adventurism’ out of its misery – and, if we’re lucky, triggers ‘the great reset’.

With Sino-American trade, the probabilities are equally loaded, and there’s never been any real chance at all of a meaningful agreement being reached between Washington and Beijing. The reality is that, for reasons seldom understood by Western observers,  but explained here, China simply cannot agree to terms that would satisfy the White House.

Through the wrong lens

Part of the perception problem is that outsiders habitually look at China through Western eyes, assuming that, like Western countries, China concentrates on the pursuit of profitable growth. This, unfortunately, simply isn’t the case. China’s priorities in economic policy are wholly different, with profitability mattering hardly at all, and the focus emphatically on volume.

The basis of government in China is “the mandate of heaven”, a term which translates as government by consent. To be sure, China has impressively comprehensive surveillance and coercion capabilities, but nobody should assume that these could keep the party (the CPC) in power if the public turned against it.

Rather, the relationship between governing and governed rests on a “grand bargain”. The public’s side of this bargain is the acceptance of civil rights which are a lot more restricted than has been the norm in the West. In return, the authorities are required to deliver prosperity.

This, undoubtedly, they have thus far succeeded in doing. According to SEEDS (the Surplus Energy Economics Data System), the average Chinese person is 44% more prosperous now than he or she was just ten years ago. This achievement is all the more remarkable when set against the gradual but relentless deterioration of prosperity in the West.

Nobody should assume, though, that continuation of improvements in prosperity is assured. Rather, the bar keeps getting higher, and one of the themes explored here is the growing extent to which China has had to resort to increasingly dangerous financial expedients to keep prosperity growth on track.

The litmus-test of whether the government is keeping its side of the bargain is employment, especially in urban areas. Both theory and evidence illustrate that, whilst rural unemployment seldom brings about unmanageable unrest, urban unemployment both can, and has. The spectre which stalks the nightmares of the Chinese leadership is mass unemployment in the cities, a problem whose potential risk has grown steadily as millions have migrated from the countryside.

At all costs, then, China must sustain and grow urban employment. This in turn points to two criteria seldom recognized in the West – an emphasis on activity (rather than profit), and a single-minded concentration on volume (rather than value).

If China were to agree to restrict her exports of goods to the United States, her volume priority would take a huge hit – and meeting America stipulations on technology transfer could risk China’s goods falling so far behind competitor product specs that they would be barely saleable, almost irrespective of quite how far prices were allowed to fall.

These considerations indicate that China simply cannot afford to agree to the most important American demands over trade, which makes a deal implausible unless Washington backs down. The view taken here is that, whilst the United States can ‘win’ a trade war with China, such a victory could be Pyrrhic at best. Based on the analysis outlined here, the Chinese economy is already in very big trouble, and America can only lose if this predicament is worsened.

The paramount emphasis on volume goes along way towards explaining why China has built huge capacity, even where there are already excesses. Building residential property where there are no residents, shopping centres without retailers, unnecessary infrastructure and unneeded factory capacity may look irrational in the West, but what to Westerners may be a white elephant looks, in China, like a valuable source of employment.

Emphasis on volume does, though, come at a hefty cost. In industry, the creation of excess capacity necessarily crushes margins. As a result, profitability often falls to levels below the cost of capital, whilst cash flow is nowhere near sufficient to finance investment in additional capacity.

This, in turn, has forced a reliance on debt, which is used not just to fund capacity expansion, but to cover losses as well.

Overseas observers customarily ignore China’s reliance on debt, sometimes because they are simply dazzled by reported “growth”. Many people overseas marvel that China has more than doubled her GDP (+114%) since 2008, but far fewer recognize that doing this has required a near-quadrupling of debt (+284%) over the same period.

In the years since the 2008 global financial crisis (GFC), annual net borrowing in China has averaged 24% of GDP, a ratio to which not even Ireland has come close.

Stated at constant 2018 values, a RMB 47.3 trillion expansion in GDP has been accompanied by RMB 162 tn escalation in debt. Tellingly, almost 60% of that borrowing has been undertaken by businesses, whose debt at constant values has climbed to RMB 134 tn, now from just RMB 38 tn ten years ago.

The cracks appear

Unfortunately, both in activity and in finance, China seems to have hit a brick wall in the second half of last year.

Financially, the first cracks in the system showed up with a catastrophe in P2P (peer-to-peer) lending, a boom-to-bust event with distinct parallels to the subprime mortgage disaster experienced in the US and in other Western countries in the lead-up to 2008.

Like subprime, P2P offers high-cost loans to borrowers unable to obtain credit from conventional (and much less expensive) sources. The very fact that borrower quality is so low ought to warn investors off these platforms, but the allure of high yields has proved irresistible to many Chinese savers.

First legalized in 2015, numbers of P2P platforms exploded, to a peak of over 8,000 by mid-2018, by which point the sums invested had reached the equivalent of $190bn. Then, with grim inevitability, P2P began to disintegrate, with some borrowers defaulting, whilst others simply absconded. By the end of July last year, after regulators had started to involve themselves, more than 4,700 P2P platforms had ceased to exist.

This in turn has had seriously adverse economic effects, some of which put the first visible dent into Chinese volumetric progression. The sectors hit first by the P2P crash have been the sales of vehicles and domestic appliances, both of which had benefited from P2P-funded purchasing.

Within corporate borrowing, China has followed the West in making ever greater use of bond finance rather than bank lending. From negligible levels ten years ago, Chinese corporate bond issuance soared to $590bn in 2016, and has remained at very high levels since then, dwarfing all other emerging market (EM) issuance put together. The number of issuers has soared to 1,451 from just 68 ten years earlier, whilst the outstanding aggregate has climbed from $4tn to almost $20tn.

Of course, China hasn’t been the only reckless user of bond issuance – indeed, the American use of bond finance for stock buybacks belongs in its own category of insanity – but, once again, cracks are starting to emerge, and are showing up in defaults.

According to US credit rating agency Fitch, defaults by Chinese companies soared to record levels last year, with 45 companies defaulting on a total of 117 bond issues. Of these companies, six were state-owned entities (SOEs), whose failures give the lie to the long-standing investor assumption that Beijing would never allow an SOE to default.

A particular complication in China is that domestic credit rating agencies seem to be ‘generous’ in the ratings that they confer. The inferred claim that most Chinese corporate bond issues are rated AA or above – with very few in junk territory – simply defies logic. A significant number of Chinese corporates enjoy AAA ratings, something that only two American companies have been accorded.

The risk here is not simply that rates of default will continue to accelerate, but that companies will face escalating debt service costs as their status slides from investment grade into junk.

An additional twist has been defaults by companies which, according to reported numbers, should have had cash holdings far exceeding the sums on which they defaulted. One company defaulted on bonds worth RMB 139 million despite supposedly having cash of about RMB 4 billion in cash holdings. A second, supposedly sitting on RMB 4.9 bn in cash, defaulted on a bond worth just RMB 300m. A third defaulted on a RMB 1bn bond even though cash had been reported at RMB 15bn.

Thus far in 2019, default rates are continuing to soar. In the first four months of this year, Chinese companies have defaulted on RMB 39.2 bn ($5.78bn) of domestic bonds, 3.4 times the total for the same period in 2018.

Tumbling volumes

These disturbing financial trends are showing up in some dramatic reversals in economic activity.

First to suffer were sales of vehicles and domestic appliances, both of which had hitherto been funded extensively with P2P credit. In comparison with year-earlier figures, sales of cars in China fell by nearly 12% in September and October last year, by 13.9% in November and by 13.0% in December. These falls constituted a dramatic reversal in hitherto uninterrupted, multi-year expansion in annual car purchasing, which had soared from 5.2 million units in 2006 to 24.7 million in 2017. Though foreign car-makers have suffered sharp decreases in sales, domestic manufacturers have borne the brunt of the slump, an event which has had very severe consequences for businesses which supply the vehicle industry.

Industries in China have also suffered from a sharp downturn in the market for consumer goods, ranging from smartphones to domestic appliances, the latter being hit further by tightened regulations on multiple home ownership. Overseas investors started to notice these trends when they were reported by companies operating in China, though, for the more observant, the sharp deterioration had been flagged already by troubled component suppliers.

Apple was one of many companies caught flat-footed by the reversal in the Chinese market, admitting ruefully that “we did not foresee the magnitude of the economic deceleration, particularly in Greater China”.

Even more significantly, suppliers of industrial components started to suffer from sharp falls in orders. The CEO of Nidec – a Japanese supplier of electric motors to manufacturers of products which include disc-drives, vehicles, robotics and domestic appliances – has said that “[w]hat we witnessed in November and December was just extraordinary”. In a letter to shareholders, Nidec called recent events “a real punch in the gut”.

FedEx, another company shocked by the Chinese turndown, has said that “no markets will be able to absorb more than a fraction of what China produces”.

The magnitude of the downturn in China is now showing up in global macroeconomic indicators – trade volumes have slumped with a rapidity not seen since 2008, whilst flows of FDI (foreign direct investment) have fallen far more sharply than can be explained by US tax changes alone.

There is growing evidence, too, that Chinese investors have started pulling out of property and other investments in overseas markets. Even before trade disputes really heated up, Chinese FDI in the United States had collapsed, whilst Chinese investors were also scaling back their investments in Europe. Towards the end of last year, in a clear reflection of economic deterioration, Chinese equity markets fell sharply, tumbling to levels last seen before the 2008 crash.

Turning on the taps

Inevitably – and despite prior commitments to do no such thing – the Chinese authorities have been pouring eye-watering amounts of new liquidity into the system since the start of this year. This has helped Chinese capital markets recover, of course, but seems to have done nothing more than buy some time for the economy itself, with key volume indicators (such as vehicle sales) continuing to fall sharply.

These interventions are starting to get noticed, puncturing much long-standing overseas complacency about China as an ‘unstoppable growth engine’. Pointedly, Forbes magazine recently asked why, if the Chinese economy really is growing at over 6%, “is the People’s Bank of China (PBOC) pumping money into the market like a drunken sailor?”

It may not be at all fanciful to detect a sense of near-panic in Beijing. Having already called on state banks to lend more to SMEs (small- and medium-sized enterprises), Premier Li Keqiang has now called for greater “flexibility” in the use of monetary policy to encourage lending. The word “flexibility”, of course, has a particular meaning when applied to monetary policy.

As well as implementing stock purchases, the PBOC has loosened reserve requirements – enabling banks to increase lending against any given amount of capital – and seems to be relaxing some of the rules previously put in place to restrain the bubble in residential property prices. Credit stimulus totalled RMB 4.64tn – more than 5% of annual GDP – in January alone, and has continued throughout the year so far at rates suggesting that 2019 will witness another big leap in Chinese indebtedness.

What now?

What we’re seeing, then, is the first major setback to an economic model targeted on volume and supported by ultra-rapid credit expansion. Though some of us have been warning about the pace of Chinese debt expansion over an extended period, Western markets seem only to have become aware of these risks since volumetric indicators turned down, a trend whose impact has been highlighted by its consequences for a string of overseas companies which, hitherto, had been riding the expansionary wave in Chinese economic activity.

Perhaps the single most disturbing feature of the Chinese predicament has been the sheer scale of the downturn across a string of product categories ranging from cars and smartphones to industrial components. What we’ve been witnessing, across a diverse and representative cross-section of activity, hasn’t been a minor reversal, still less a slowing of growth, but an alarmingly deep fall in activity.

It need hardly be said that China has played an absolutely pivotal role in the world economy since 2008, not just providing growth but acting as a hugely important market for everything from manufactured goods to critical commodities, including energy, minerals and food. Additionally, Chinese overseas investment has been hugely important for overseas asset prices, most obviously in real estate.

The risks from here are (a) that activity continues to fall rapidly, and (b) that the financial system that has funded the push for volume starts to decay.

We can be pretty sure that, in terms of stimulus, China will do anything and everything possible to arrest the downwards lurch. Even on a comparatively optimistic reading, however, trade, investment and demand, worldwide, are going to take a major hit from what has already happened in China.

The really big question, in China as elsewhere, is whether the efficacy of financial stimulus will weaken, something which could happen if credit exhaustion kicks in, or if faith in money is undermined.

It’s worth reminding ourselves of quite how far we have already gone in reliance on cheap debt and abundant liquidity. Over five years, only stock buybacks of $2.95tn, mostly debt-financed, have kept Wall Street buoyant in the face of net investor selling of $1.1tn, whilst the Bank of Japan has now acquired more than half of all outstanding JGBs (Japanese government bonds) using money newly created for the purpose.

Stirring Chinese economic and financial risk into the mix suggests that we may be measurably close to the point at which the seaworthiness of the ‘perpetual cheap money lifeboat’ meets its toughest test.