October 30 – BloombergView (By Matthew A. Winkler): “Ignore China’s Bears: There's a bull running right past China bears, and it’s leading the world’s second-largest economy in a transition from resource-based manufacturing to domestic-driven services such as health care, insurance and technology. Just when the stock market began its summer-long swoon, investors showed growing confidence in the new economy -- and they abandoned their holdings in the old economy. These preferences follow Premier Li Keqiang's directive earlier in the year at the National People's Congress to ‘strengthen the service sector and strategic emerging industries.’”
Bubbles always feed - and feed off of - good stories. Major Bubbles are replete with great fantasy. Even as China’s Bubble falters, the recent “risk on” global market surge has inspired an optimism reawakening. August has become a distant memory.
In the big picture, the “global government finance Bubble – the Granddaddy of all Bubbles” is underpinned by faith that enlightened global policymakers (i.e. central bankers and Chinese officials) have developed the skills and policy tools to stabilize markets, economies and financial systems. And, indeed, zero rates, open-ended QE and boundless market backstops create a “great story”. Astute Chinese officials dictating markets, lending, system Credit expansion and economic “transformation” throughout a now enormous Chinese economy is truly incredible narrative. Reminiscent of U.S. market sentiment in Bubble years 1999 and 2007, “What’s not to like?”
Never have a couple of my favorite adages seemed more pertinent: “Bubbles go to unimaginable extremes – then double!” “Things always turn wild at the end.” Well, the “moneyness of Credit” (transforming increasingly risky mortgage Credit into perceived safe and liquid GSE debt, MBS and derivatives) was instrumental the fateful extension of the mortgage finance Bubble cycle. At the same time, Central banks and central governments clearly have much greater capacity (compared to the agencies and “Wall Street finance”) to propagate monetary inflation (print “money”). Most importantly, this government “money” and the willingness to print unlimited quantities to buttress global securities markets now underpin securities markets on a global basis (“Moneyness of Risk Assets”). And unprecedented securities market wealth underpins the structurally impaired global economy.
China has been a focal point of my “global government finance Bubble” thesis. Unprecedented 2009 stimulus measures were instrumental in post-crisis global reflation. Importantly, China - and developing economies more generally - had attained strong inflationary biases heading into the 2008/09 crisis. Accordingly, the rapid Credit system and economic responses to stimulus measures had the developing world embracing their newfound role of global recovery “locomotive”. I contend that the associated “global reflation trade” was one of history’s great speculative episodes. I have posited that the bursting of this Bubble (commodities and EM currencies) marks a historical inflection point for the global government finance Bubble. I find it remarkable that this analysis remains so extremely detached from conventional thinking.
Conventional analysis revels in seemingly great stories. As an analyst of Bubbles, I methodically contemplate a fundamental question: Is the underlying finance driving the boom sound and sustainable? Over the past 25 years, I’ve pondered this puzzle on too many occasions to count – about market, asset and economic Bubbles - at home and abroad. Arguably, it’s been 25 years of progressively destabilizing global Monetary Disorder. Looking today at the U.S., Europe, Japan and EM – I strongly believe the underlying finance driving the lackluster boom is hopelessly unsound. I as well appreciate that today’s acute monetary instability remains inconspicuous to most analysts.
As a macro analyst, I view China as the global Bubble’s focal point – the weak link yet, at the same time, the key marginal source of Bubble finance. In the short term, China’s ability to stabilize its stock market, incite lending and reestablish their currency peg have been instrumental in the resurgent global “risk on” backdrop. At the same time, I’m confident that the underlying finance driving this historic Bubble is unsound. This will remain a most critical issue.
I have argued that the global government finance Bubble elevated “too big to fail” from large financial institutions to encompass global risk markets more generally. Importantly, so-called “moral hazard” and associated risk misperceptions evolved into a global phenomenon. And nowhere has this dynamic had more far-reaching consequences than in China. Underpinned by faith that China’s policymakers will backstop system liabilities (i.e. deposits, intra-bank lending, etc.), Chinese banking assets (loans and such) have inflated to double the size of the U.S. banking system. China’s corporate debt market has ballooned to an incredible 160% of GDP (double the U.S.!), again on the view of central government backstops. Then there’s the multi-Trillion (and still growing) “shadow banking” sector, possible only because investors in so-called “wealth management” products and other high-yielding instruments believe the government will safeguard against loss.
International investors/speculators have been willing to disregard a lot in China. Corruption has been almost systemic. The historic scope of malinvestment is rather conspicuous. China is in the midst of a historic apartment construction and lending Bubble. There’s a strong case to be made that the amount of Chinese high-risk lending is unprecedented in financial history. The massive Chinese banking system is today vulnerable from the consequences of extremely unsound lending to households, corporations and local governments. Chinese lenders are also likely on the hook for hundreds of billions of loans provided to finance China’s global commodities buying binge.
Throughout the now protracted boom, perceptions have held that Chinese officials have things under control. And with a massive trove of international reserves, the Chinese have been perceived to possess ample resources for stimulus as well as banking system recapitalization, as necessary. Erratic Chinese policy moves were widely assailed this summer. And while down $500 billion over recent months, China’s $3.5 TN of reserves have been sufficient to underpin general confidence (once Chinese officials convinced the marketplace that they would stabilize their currency).
Last week’s CBB succumbed to the too colorful language “Credit and Currency Peg Time Bomb.” China’s policy course appears to focus on two facets: to stabilize the yuan versus the dollar and to resuscitate Credit expansion. For better than two decades, similar policy courses were followed by myriad EM policymakers in hopes of sustaining financial and economic booms. Many cases ended in abject failure – often spectacularly. Why? Because when officials resort to such measures to sustain faltering Bubbles it generally works to only exacerbate systemic fragilities. For one, late-stage reflationary measures compound Credit system vulnerability while compounding structural impairment to the real economy. Secondly, central bank and banking system Credit-bolstering measures create liquidity that invariably feeds destabilizing “capital” and “hot money” outflows.
As the globe’s leading superpower and master of the world’s reserve currency, the U.S. has experienced quite contrasting dynamics (to EM). The U.S. financial system has enjoyed the freedom to aggressively expand Credit, with “capital” and “hot money” outflows invariably (and effortlessly) “recycled” right back into U.S. financial assets. With U.S. corporations, households and financial institutions borrowing almost exclusively in dollars, the Fed has enjoyed extraordinary flexibility when it comes to monetary inflation. Post-tech Bubble reflationary policies and dollar devaluation did not risk an EM-style asset/liability currency mismatch. Moreover, post-mortgage finance Bubble QE-amplified liquidity outflows were largely absorbed by China and EM central banks as they accumulated international reserve holdings (flows conveniently recycled back into Treasury and agency securities).
Importantly, faith in the dollar as the unrivaled global reserve currency underpinned confidence in Federal Reserve Credit – while the unfettered inflation of Fed Credit underpinned confidence in the U.S. securities markets and financial system right along with the American economy. It’s worth noting also that the juggernaut German economy has provided considerable flexibility to the ECB and euro currency and Credit management. Unique attributes have also thus far afforded the Bank of Japan phenomenal stimulus and devaluation latitude without inciting a crisis of confidence in the yen or Japanese financial assets. Overall, faith in central bank Credit has inflicted immeasurable damage.
Conventional thinking holds that China’s currency is on the verge of “reserve” status. It is believed that Chinese officials will enjoy similar dynamics and policy flexibility as the U.S., Europe and Japan. The “Credit and Currency Peg Time Bomb” thesis rests upon the view that China is not a leading “developed” economy, but rather one massive “developing”-economy Credit and economic Bubble. I could be wrong on this. But the issue “Developing or Developed?” has profound ramifications for China’s future, as well as for global finance, the international economy and geopolitics more generally.
China presents the façade of a highly advanced, high-tech “developed” economy. But in terms of corruption, reckless lending and state-directed uneconomic investment – China is “developing” at its core. In terms of corporate governance – it’s “developing”. Extreme wealth disparities? Right, “developing.” The government’s obtrusive role in finance and in the real economy, on full display over recent months, is pure “developing.” In short, China simply doesn’t have the history, capitalistic institutional structures or governance to function as a grounded and well-developed market economy. They were moving in the right direction before fatefully losing control of finance.
I really hope China pulls out of this Bubble period without calamity. But I fear they are locked in a precarious policy course of perpetual Credit excess - a progressively unsound Credit boom destined for a crisis of confidence. They face constant “capital” outflow pressures – from both domestic-based and international sources. Wealthy Chinese will continue to try to get “money” (and their families) out of the country, as international investors and speculators flee an increasingly chaotic backdrop. How enormous is the Chinese speculative “carry trade” playing high-yielding Chinese debt instruments?
I used “time bomb” terminology because throwing previously inconceivable quantities of new Chinese Credit atop “Terminal Phase” excess ensures exponential growth in systemic risk. Ironically, the huge reserve holdings – perceived to support systemic stability – actually ensure excesses are allowed to run unchecked to catastrophic extremes. I expect “capital” flight will continue to deplete reserve holdings. Markets will fret covert activities employed to support the yuan and bolster reserves. At some point, the markets will contrast the rising mountain of problem and suspect loans (and bonds) to the dwindling stock of reserves - and turn jittery. At some point there will be plenty to worry about in the Chinese banking system and corporate debt markets.
I expect the downside of this historic Credit cycle to come with negative currency ramifications. Reminiscent of the nineties SE Asian Bubbles, Chinese officials are keen to postpone the day of reckoning. Rather than more gradual and less disruptive currency devaluation, determination to cling to reflationary policies coupled with a pegged currency regime ensures a major currency dislocation becomes part of a disruptive general crisis in confidence.
At the end of the day, the massive unabated inflation of government finance – the unprecedented issuance of sovereign debt and central bank Credit - ensures a crisis of confidence in the underlying value of this “money.” Unfettered “money” in the hands of politicians and contemporary central bankers is risky business. Confidence in EM finance has waned, although an ebb and flow has seen sentiment improve over recent weeks. Optimism’s revival has much to do with perceptions of China’s stabilization. Count me skeptical that confidence in China is anything more than skin deep. “Developing or Developed?” How long will they enjoy the flexibility of unfettered Credit and a currency tied to the dollar?