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Musings Report #28 7-11-15 China's Financial Revolution and Financial Typhoon
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China's Financial Revolution and Financial Typhoon
The typhoon that's about to hit Shanghai is a real-world analogy of the financial typhoon that is hitting China's stock market and more importantly, the driver of that froth, the credit bubble that arose in the financial revolution of the past seven years.
The story of China's economy is not just the conventional narrative of attracting foreign capital, joining the global economy as the world's workshop, urbanizing a vast rural population and leading the world in growth: it's the expansion of credit that outpaces China's growth.
As the McKinsey Global Institute reported in February of this year (in a report on global debt titled "Debt and (Not Much) Deleveraging"):
"China’s total debt has quadrupled, rising from $7 trillion in 2007 to $28 trillion by mid-2014. At 282 percent of GDP,China’s debt as a share of GDP, while manageable, is larger than that of the United States or
Germany.
Several factors are worrisome: half of loans are linked directly or indirectly to China’s real estate market, unregulated shadow banking accounts for nearly half of new lending, and the debt of many local governments is likely unsustainable."
Global debt has grown by $57 trillion since 2007, of which $21 trillion occurred in China. China accounted for 37% of total global debt growth while its economy measured by GDP is about 13% of global GDP.
In other words, China has achieved its growth since 2007 by expanding its debt at a rate that far exceeds its GDP growth.
Add in the likelihood that real debt in the opaque shadow banking sector (i.e. private debts that are not recorded by official data collection) is much higher than reported, and the vast malinvestment in sports stadiums, gargantuan retail malls, etc. that will never pay for the costs of their construction and upkeep, and you have a far grimmer picture in which debt in China is more likely 400% of GDP and far more leveraged than advertised.
Correspondent Lance D. suggested I address the widespread notion that China's currency, the RMB (renminbi or yuan), is about to join the U.S. dollar as a global reserve currency.
This is closely related to another popular notion, that China holds enormous reserves of gold and that it will gain global supremacy by backing its currency with gold, as the U.S. did prior to 1971.
Although I understand the appeal of these ideas, and the natural tendency to assume China's currency will reflect its larger role in the global economy, the reality is that China will have to overcome a number of systemic hurdles to have a truly global currency.
1. China will have to let the RMB float, i.e. unpeg it from the dollar. That China has maintained the "training wheels" of a peg to the USD for 30+ years is extraordinary. The only other nations that maintain a peg to the dollar (or use the USD as their national currency) are small nations such as Costa Rica.
Why has China maintained this peg, essentially locking its currency and economy to the USD? The reason is fear of the consequences of a free-floating RMB: should the RMB strengthen substantially, Chinese exports would suffer as their cost rose in other currencies. If the RMB weakened dramatically, essential imports (iron ore, oil, food) would soar in cost for Chinese firms and households.
The one key fact about the currency market is that no nation or central bank can control it for long, due to its vast size. Currency markets trade about $3 trillion per day, which is roughly the size of China's entire foreign reserves and 25% of its annual GDP. Once China lets the RMB float, it will lose control of its international valuation.
For a central-planning/command economy, that prospect is sobering, for the value of a currency impacts not just global trade but the domestic economy as well.
2. Currencies are tied to bond yields and bond risks. When bonds pay next to nothing or are considered risky, the currency reflects these factors. In effect, no currency can float freely unless the bond market of the issuing nation is also allowed to float. China will have to open its bond market, and that will enable buyers and sellers to set the value. That is a risky proposition to a leadership accustomed to controlling virtually every lever of the Chinese economy.
3. Currencies are tied to current account (trade) deficits and surpluses. If a nation runs a large trade surplus, it is exporting its goods and receiving other currencies in exchange for the goods, If a nation has a trade deficit (i.e. imports more than it exports, like the U.S.), then it is exporting its currency in exchange for goods from other nations.
4. To establish a reserve currency, China will have to run a large, structural trade deficit with the rest of the world, i.e. export its currency in vast quantities, in order to supply the global economy with the trillions needed to grease trade and maintain reserves.
China runs a trade surplus, and so there is no mechanism to export enough currency to others to become a reserve currency. This is a consequence of Triffin's Paradox, which I have covered extensively in the blog for years. Triffin's Dilemma is not an intuitive topic, and hence it is poorly understood, even among supposedly expert economists.
Which brings us to China backing the RMB with gold. Setting aside the opaque nature of China's gold reserves (nobody knows how much gold China holds), the problem with a gold-backed reserve currency is a second-order effect of Triffin's Paradox:
if you want a reserve currency, you must be a large exporter of currency, i.e. run a large trade deficit, year in, year out.
If you run a trade deficit, then those nations obtaining your currency in exchange for their exports to your country can demand gold in place of your currency. That's what backing a currency with gold means: the currency is convertible to gold at a rate of X units of currency per ounce of gold.
This is why the U.S. abandoned the gold standard, and why it is impossible for any nation to maintain a gold-backed currency and a global reserve currency in a world of fiat currencies: to have a reserve currency, you must run a large trade deficit, which means gold will be flowing out of your reserves as those holding your currency trade the currency for gold.
Why would they do this? Gresham's Law, which is "bad money drives out good money." Which would you rather have in times of uncertainty/risk--gold, or an RMB note that is supposedly exchangeable for gold? If you hold the RMB, the risk is that the Chinese government might change the peg to gold or rescind the convertibility of the RMB to gold at will. Anyone owed RMB would be smart to demand gold rather than the paper currency, which can be revalued by Chinese authorities at will. People will hoard the gold, not the RMB.
For all these reasons, it is unlikely China, with a debt load of 300% to 400% of GDP and a set of deflating asset bubble, will let its currency and bonds float freely and hope to control their valuation in the global market. That is the trade-off: you either keep control or you let them float. You can't have both. You can influence their valuation (by raising and lowering yields on bonds, for example), but that's not the same as total control.
I think it is fair to say that the global solution to stagnation since 2007 has been an unprecedented expansion of debt, and China has supercharged this expansion of debt to sustain its growth. This quadrupling of debt and expansion of leverage and shadow banking is China's Financial Revolution, and the full ramifications of this revolution are as yet unknown. The deflation of China's unprecedented bubbles in real estate and stocks is a Financial Typhoon that has yet to reach landfall.
Limiting people from selling not only smacks of desperation, it is counterproductive, for it shows that 1) the government failed to stop a 30% decline in stocks and 2) the government is attempting to corral everyone who bought in and not let them sell. The message to those who bought in and have lost money: sell as soon as you can, and sell it all.
These desperate policies communicate something else: China's willingness to limit selling when it doesn't align with the leadership's expectations. The problem with this is global traders of bonds and currencies have no interest in buying assets that they will be unable to sell as soon as prices soften. Being able to sell at will is the very definition of a market. Take that away, and you have no market.
The bar for launching a fully floating reserve currency is high, and it doesn't appear China is ready to accept the risks and uncertainties that go along with floating currencies and bonds and supporting a reserve currency.
Summary of the Blog This Past Week
Is Greece a Template for US State & Local Government Debt Crises? 7/11/15
Maintaining the Illusion of Stability Now Requires Ever-Greater Extremes 7/10/15
Trouble Abrewing: This Time It Is Different 7/9/15
No Jobs for the Young, No Retirement for the Old 7/8/15
Ragin' Contagion: When Debtors Go Broke, So Do Mercantilist Exporters 7/7/15
Greece's New Money: Many, Not One? 7/6/15
Best Thing That Happened To Me This Week
First peach of the season--very sweet, satisfying result from careful nurturing and feeding of our old tree.
Market Musings: Revisiting the Dollar
In May, I posted this chart in the Musings, showing potential retracement levels for the USD around 94 and 88.
In this updated chart, we see the USD dipped slightly below 94 and has recently broken its short-term downtrend.
With MACD approaching a bullish cross, we may see another drop in the USD as euphoria over a phony "Greece is fixed" rally pushes the USD down and the euro/yen up.
When reality sets in, the USD may well resume its uptrend, and push much higher than the majority of punters believe possible.
From Left Field
12 charts and maps that explain the Greek crisis
Record 62% of households in Japan face financial hardship -- yikes... beneath the MSM radar...
Losing Paradise: Climate Change is Changing Mt. Rainier
Brick-laying robot can build a full-sized house in two days
25 of the most majestic libraries in the world -- worth a look...
The "Sharing Economy" is the Problem: The Cooperative Economy is the Solution
A Perfect storm ; Population, Technology & Agriculture
“In the next 40 years, farmers will have to grow as much food as they have in the last 10,000 years - combined.”
China's Manufacturers Are Shifting Towards Zero-Labor Factories -- they have choice...
The Frenzy About High-Tech Talent: there's not enough jobs for STEM graduates
Automation comes with a price. Germany vs. Greece.
These Neighbors Got Together to Buy Vacant Buildings. Now They’re Renting to Bakers and Brewers
A Pain in the Athens: Why Greece Isn't to Blame for the Crisis
"We’ve never understood Greece because we have refused to see the crisis for what it was—a continuation of a series of bailouts for the financial sector that started in 2008 and that rumbles on today. It’s so much easier to blame the Greeks and then be surprised when they refuse to play along with the script."
"Yesterday I was clever, so I wanted to change the world. Today I am wise, so I am changing myself." Rumi
Thanks for reading--
charles |
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