"The shift to ‘tapering’ when the global economy appears under strain now leaves investors in a quandary. The fact that investors have begun to question the effectiveness of further asset purchases and whether much more can be provided without causing financial instability has roiled investor mindsets. The most recent Fed Minutes have unveiled these as valid concerns. The impact of ‘tapering’ along with the challenges exposed in China (Trust securities), Japan (Abenomics and imported energy costs), and EM countries (capital outflows and interest rate hikes) are forming a toxic mix for risk-assets." - ScotiaBank
The Primary-dealer intermediated US Treasury issuance model is well-known to virtually everyone (and if it isn't, today the TBAC has released a convenient presentation explaining all the nuances for those who may not be familiar with all the aspects of just how the US Treasury auctions off bonds). But how does the rest of the developed world fund its budgeting needs? The following table from the TBAC presentation provides all the answers.
Who stole the people's money?
Investors in China have been running scared of a default on a high risk trust product; but, as Bloomberg's Tom Orlik notes, they should embrace it. The implicit guarantee that no investments will go sour is one of the key problems with China’s financial system as Orlik adds it encourages reckless lending often to borrowers whose only merit lies in backing from a deep-pocketed government. Crucially, as JPMorgan warns in a recent note, "avoiding defaults is not the right answer, as it will only delay or even amplify the problem in the future." A default that encourages lenders to price in risk would be a positive development and the CEG#1 was an ideal product to 'fail' with its 11% yield and clear idiosyncratic company problems. However, regulators won't have to wait long for a second chance as JPM warns "There will be a default in China’s shadow banking industry this year as economic growth momentum slows."
In a 2-line statement, offering very few details, ICBC's China Credit Trust Co. said it reached an agreement to restructure the CEG#1 that ha sbeen at the heart of the default concerns in recent weeks. The agreement includes a potential investment in the 3 billion-yuan ($496 million) product but didn’t identify the source of funds, or confirm whether investors would get all of their money back. The media is very excited about this entirely provisional statement and we note, as Bloomberg reports, investors in the trust product must authorize China Credit Trust to handle the transaction if they want to recoup their principal which will involve the sale of investors' rights in the trust at face value (though no mention of accrued interest). As BofAML notes, however, "the underlying problem is a corporate sector insolvency issue... there may be many more products threatening to default over time," and while this 'scare' may have raised investors' angst, S&P warns "a bailout of the trust product [leaves] Chinese authorities with a growing problem of moral hazard," and they have missed an opportunity for "instilling market discipline."
Overview of forces impacting stocks, bonds and currencies.
A paper currency system contains the seeds of its own destruction. The temptation for the monopolist money producer to increase the money supply is almost irresistible. In such a system with a constantly increasing money supply and, as a consequence, constantly increasing prices, it does not make much sense to save in cash to purchase assets later. A better strategy, given this scenario, is to go into debt to purchase assets and pay back the debts later with a devalued currency. Moreover, it makes sense to purchase assets that can later be pledged as collateral to obtain further bank loans. A paper money system leads to excessive debt. This is especially true of players that can expect that they will be bailed out with newly produced money such as big businesses, banks, and the government. We are now in a situation that looks like a dead end for the paper money system.
China faces a very significant test of its reform policy pursuit rhetoric. With China's Bank regulator set to issue an alert on coal-industry loans - "as a result of outout cuts, they don't have much cash flow and thus they can't repay loans and debt," the massive growth in wealth products such as the CEG#1 (which offered a 10% yield for a 3 year term) based on these loans leaves the Chinese with a moral hazard dilemma - bailout or no bailout. ICBC has made it clear it wil not bailout investors since reputational damage would be "well manageable," and former-PBOC adviser Li Daokui adds that "a controlled default is much better than no default," noting critically that trust defaults "will teach future investors a very important lesson." Belief that contagion can be "contained" brings back memories of 2008 in the US but a total (or even partial) bailout will merely increase the leverage and risk-taking problem and signal government talk of policy reform is not real.
As we first reported one week ago, the first shadow default in Chinese history, the "Credit Equals Gold #1 Collective Trust Product" issued by China Credit Trust Co. Ltd. (CCT) due to mature Jan 31st with $492 million outstanding, appears ready to go down in the record books. In turn, virtually every sellside desk has issued notes and papers advising what this event would mean ("don't panic, here's a towel", and "all shall be well"), and is holding conference calls with clients to put their mind at ease in the increasingly likely scenario that there is indeed a historic "first" default for a country in which such events have previously been prohibited. So with under 10 days to go, for anyone who is still confused about the role of trusts in China's financial system, a default's significance, the underlying causes, the implications for the broad economy, and what the possible outcomes of the CCT product default are, here is Goldman's Q&A on a potential Chinese trust default.
Overview of the major forces shaping the investment climate.
Yes, financial markets are built and intended to fail at times, once they are no longer allowed to fail, they become state tools for policy outcome.
"Eventually (un-manipulated) asset prices always return to their fundamental value, which is why bubbles always pop. The FOMC has backed itself into a corner. Current changes in policy are being designed around efforts to manage the unwind process seamlessly. Central bank (and government official’s) micro-management appears based on a belief that they can exert an all-encompassing central control over markets and peoples’ lives. Those in power have come to believe that policies have a precise effect that can be defined and managed. This is highly unlikely."
The world has depended on Chinese and American stimulus for years, and, as Caixin's Andy Xie notes, one implication of their tightening is a slowing global economy in 2014.
Risk is an ever-present characteristic of life; it cannot be eliminated, it can only be masked or hedged. We know this intuitively, yet we blithely accept official assurances that risk can be eliminated by the monetary machinations of the Federal Reserve, the Central Bank of China, the Bank of Japan and the European Central Bank. To confuse masking risk with the elimination of risk is the acme of hubris and the perfect setup for disaster.
Having had a few days to reflect on the all-knowing Bernanke's words (and deeds), here are a few thoughts on what was said (and not said)...