By Doug Noland at The Credit Bubble Bulletin
I figured I would surprise readers this week and focus on China. There’s been a lot written and spoken this past week. My challenge is to put Chinese devaluation into perspective and offer unique insight.
August 12 – CNBC (Fred Imbert): “China’s decision to depreciate the yuan was presented (albeit surprisingly) to the world as a way to bolster a recently floundering economy, but Art Cashin said… that Wall Street remains concerned… ‘What’s scary here is that people are beginning to doubt the sophistication of the Chinese officials… Whether they are adept enough and clever enough to know where to move; they didn't look very adept when they were trying to save their stock market, and they're in an area where it can be a little dangerous…”
As they say, “bull markets create genius.” Let me suggest that Bubbles deserve Credit for propagating “genius” – genius in the markets, throughout the real economy and in policymaking. I recall how the brilliant, omniscient and clairvoyant “Maestro” Alan Greenspan was unconditionally revered during the late-nineties Bubble period.
Bursting Bubbles leave a mess – in the markets, throughout the real economy, in societies, in politics and with policymaking. Major Bubbles leave a trail of disarray and confusion – with the potential for a couple policy miscues to unleash mayhem. Think of the political paralysis and upheaval that has befallen Japan for the past 25 years. Think of post-mortgage finance Bubble divisiveness and political polarization here in the U.S. Look at the social tension and confused policymaking in Europe. The bursting of the historic Chinese Bubble has begun the process of eradicating genius while exposing a mess of monumental proportions.
For starters, never have so many Chinese owned (over-priced and poorly constructed) apartments. Never have Chinese citizens, governments, financial institutions and corporations accumulated so much debt. Never have the Chinese had so much invested in securities markets. China has zero experience with a multi-trillion (yuan or dollars) “shadow banking system.” Never have so many invested so much in “wealth management” vehicles and other sophisticated financial products, without a clue as to where their “money” was directed. And when it comes to corruption, I seriously doubt history offers a like comparison.
The Chinese – apartment owners, bankers, Internet financiers and policymakers – have never experienced the downside of a massive Credit Bubble. Never has China experienced Trillions of “money” that retains “moneyness” chiefly on the perception that the all-knowing central government will safeguard its value. Never have Chinese finance and spending had such major impacts around the world. China does, however, have a long history of financial panics.
A week after blaming short sellers and foreigners and employing unprecedented market intervention, officials this week espouse a preference for market forces to play a prominent role in setting the value of the Chinese currency. Credibility – so vital in markets and as the bedrock of money and Credit - can dissolve so quickly. Clearly, the Chinese will rely on market forces only so long as the markets are operating consistent with their policy aims.
A number of analysts now question to what extent Chinese officials have a strategic plan. Insight from Iron Man Mike Tyson is applicable: “Everybody’s got a plan until they get punched in the mouth.” Did the U.S. have a plan in mid-2008? Europe? Did Japan in 1989? SE Asia in 1997? Without exception, policymakers were oblivious.
Chinese officials hold grand ambitions for global economic, financial and military supremacy – a vision brought into keen focus during this protracted Bubble period. In the near-term, however, their fixation has shifted to ensuring that everything doesn’t come crashing down. Collapse would see the focus shift to villainizing foreigners, maintaining social order and retaining power – Putin’s course on a grander scale. Within Chinese government circles, there must today be a wide range of contrasting views, competing priorities and colliding policy prescriptions. There will be no coherent plan because they confront too many unknown variables – domestic and global, economic, financial and geopolitical.
Chinese officials this week were compelled to reemploy currency devaluation, a strategy scrapped in 2014 after the swift appearance of financial stress. I have read some analysis pointing to the apparent success of recent Chinese stimulus measures. This ignores key realities. Foremost, the bursting of China’s stock market Bubble marks a critical inflection point. Foreign confidence in China has been badly damaged. At home, there are cracks in public confidence in the ability of Chinese officials to manage the markets and economy. Importantly, stock market losses have begun to foment heightened risk aversion in vulnerable Chinese debt markets.
August 11 – Financial Times: “Lending in China's shadow banking sector appears to have collapsed in July, after China's equity market fell by a third and more than half of listed companies suspended their shares to avoid the turmoil. New data show that ‘aggregate financing,’ the broadest measure of Chinese new credit available, was just Rmb718.8bn ($116bn) last month — 61% lower than a month earlier… It's also 29% below forecasts. Details suggest banks flooded the market with liquidity, but that shadow banks cut off the tap. ‘New yuan loans’, which track loans in the normal backing sector, were Rmb1.48tn, almost double forecasts at Rmb750bn… It's rare for new renminbi loans to be higher than the aggregate figure, as it means shadow activity actually contracted in the month. The last time this happened at all was in early 2009.”
The abrupt decline in July system Credit growth supports my “inflection point” view regarding the Chinese stock market collapse. I had suspected that much of recent “shadow banking” expansion was funneling finance into the stock market speculative Bubble. And with market losses and risk aversion now spurring deleveraging, it will be quite a challenge for the Chinese Credit system to generate sufficient new finance to keep its maladjusted economy and massive debt mountain levitated.
It’s a fundamental Credit Bubble Tenet that Bubbles require ever increasing amounts of new Credit. And, importantly, a Bubble period prolonged by government support generates enormous ongoing Credit requirements – for the securities markets, for housing and asset markets and for spending throughout the real economy. Bubble-induced inflated price levels throughout both the Financial and Real Economy Spheres are at the root of the problem.
Massive ongoing Credit requirements to sustain Chinese financial and economic Bubbles poses a far-reaching dilemma for Chinese officials. Post-Bubble Japanese policymakers tried about everything and failed, before resorting to rank monetary inflation and devaluation. A similar fate was to befall the Europeans – so they moved more brazenly to American-style “printing” and devaluing. Here at home, our policymakers ran massive deficits, monetized Trillions, manipulated markets and blatantly devalued. Luxuriating in the advantages and benefits of “reserve currency” status, post-bubble U.S. monetization and dollar devaluation appeared painless and cost-free. EM central banks cheerfully accumulated massive Treasury holdings. China, EM and commodities Bubbled. U.S. corporate profits inflated. And in a world chiefly priced in dollars, Credit Availability boomed right along with U.S. corporate debt markets. M&A boomed. Ditto share buybacks and financial engineering.
Of course the Chinese aspire to “reserve currency” status and all the associated perks. Yet those prospects appear increasingly remote at the moment. Unlike their American, Japanese and European counterparts, Chinese officials do not today enjoy the luxury of mindlessly printing and devaluing. This limits their options and complicates policy.
We now see the strategy of pegging to the dollar coming back to bite. Their banks and corporations have accumulated more than $1 Trillion in dollar-denominated debt. The peg also incentivized massive speculative inflows – myriad “carry trade” variations. How much experience do Chinese bankers and regulators have in managing derivatives markets? How about when they are in disarray? China’s currency regime, the global monetary backdrop and the massive inflow of finance to China spurred a precarious blend of financial experimentation and engineering, commodities and EM overinvestment, domestic over- and mal-investment and historic financial and economic imbalances. Print and devalue won’t suffice.
Chinese stimulus over the past year has compounded Chinese fragilities – perhaps greatly. And now state-directed financial institutions are being used to reflate securities markets and stabilize currency trading. Various risks are flowing (flooding?) into China’s already gravely bloated financial sector. Indeed, the grossly inflated Chinese banking system – conventional and “shadow” – enters the downside of Credit and economic cycles exceptionally exposed. There’s another fundamental – and pertinent - Credit Bubble Tenet: incredible amounts of “Terminal Phase” financial and economic damage can be inflicted in relatively short order.
China is positioned at the epicenter of an unfolding global financial and economic crisis. Last week’s analysis placed China both at the “Core of the Periphery” and the “Periphery of the Core.” It is a confluence of financial and economic factors – domestically in China as well as globally – that creates acute fragility and potential for financial dislocation and deep crisis. This complexity also ensures that the risks go unappreciated by most.
It’s worth noting a few headlines from the week: “Fear of Yuan Declines Sparks Biggest Dim Sum Selloff Since 2011”; “Asia Currencies Post Worst Week Since 2011…”; “Russia Bonds Have Worse Rout in Year…”; “Malaysia Ringgit Hits Fresh 17-Year Low: stocks, bond Drop”: “Hedge Funds Bloodied by China Crash in Worst Month Since 2011”; “So How Are All Those Yuan Structured Products Doing?”; “The World’s Credit Investors Are Getting More and More Skittish”
The Malaysian ringgit sank 3.9% this week to the low since 1998. Indonesia’s rupiah fell 1.8%, South Korea’s won 1.1% and India’s rupee 1.9%. In Latin America, the Mexican peso declined 1.3% and the Colombian peso fell 1.9%. The Turkish lira dropped 1.9%. The Russian ruble fell 1.4%. South Africa’s rand declined 1.6%. Here at home, junk bond funds suffered a third straight week of significant outflows.
European luxury manufacturers’ stocks were hammered. Germany’s BMW and Daimler each sank about 6%. I saw analyst comments suggesting that, since the manufacturer of Mercedes Benz hedges currency risk, the selling was overdone. This misses the key point: The seemingly boundless Chinese “money” spigot where hundreds of billions stoke demand for virtually everything luxury around the world, including U.S. real estate, is suddenly in jeopardy.
Curiously, there was little initial response in yen trading to Tuesday’s Chinese devaluation. The yen then surged an immediate 1% after the PBOC followed through Wednesday with a second devaluation. Quickly, fears arose that the Chinese might be in the process of orchestrating a significant devaluation – a strategy that could easily spiral out of control. Global markets were increasingly unstable with “risk off” (de-risking/de-leveraging) gathering momentum. European equities suffered a second day of steep declines (DAX and CAC down another 3%), as risk indicators jumped globally. U.S. stocks also traded sharply lower before yet another well-timed rally worked its magic. Global markets further stabilized as Chinese central bankers took unusual measures to allay devaluation fears.
The “currency war” issue garnered deserved attention this week. With currency markets in disarray and disinflationary pressures mounting globally, increasingly desperate central bank measures attempt to spur inflation. “Enrich thy neighbor” – Ben Bernanke’s answer to “beggar thy neighbor” concerns – sounds even more ridiculous these days. Asian currencies were under intense pressure this week. Perhaps it’s related to fears of a cycle of competitive devaluations. Mainly, I believe it is part of an intensifying exodus of “hot money” from a region especially vulnerable to financial contagion, instability and even calamity. And the more currencies weaken the more unmanageable the debt loads. Chinese devaluation only stokes this fire.
This week’s 2.8% currency decline (vs. the dollar) offers little relief to Chinese manufactures. And while I do believe the Chinese economic downturn has gained important (post-stock market Bubble) momentum, I don’t see economic weakness as the driving force behind this week’s policy move. Chinese officials are alarmed about a sudden Credit slowdown and the risk of a self-reinforcing deflationary dynamic. The Chinese are fearful of their increasingly fragile Credit system.
Currency pegs are dangerously seductive. The longer they remain in place the more advantageous they appear. They are pro-“hot money” flows. Over time they become increasingly pro-leverage and speculation. They are pro-Bubble – which means pro-tantalizing boom. In the end, currency peg regimes ensure precarious financial and economic imbalances. And, repeatedly, derivatives markets have become the epicenter of boom and bust dynamics. Peg the two most important global currencies together, adopt flawed policies, let Bubbles run loose, promote historic expansions of “money” and Credit - and you’re asking for trouble.
Most view the Chinese currency as fundamentally strong. Surely Chinese policymakers see it this way. After all, China has a colossal export sector. The People’s Bank of China is sitting on an unmatched $3.7 TN hoard of international reserves. But is the currency sound? What are intermediate to longer-term prospects? How fragile is the Chinese Credit system? How much central government debt and monetization will be employed to counter a Credit and economic bust?
EM busts notoriously leave policymakers hamstrung. As “money” flees, EM central banks lose flexibility. Printing “money” only exacerbates outflows, currency weakness and financial turmoil. As we’re seeing with an increasing number of EM countries, the pressure is for central banks to tighten policy to arrest currency weakness and attendant inflationary pressures. Will China, with its $3.7 TN, be able to escape typical EM dynamics? From certain angles China may appear “developed.” Yet the manner in which it has mismanaged its Credit system has been tell-tale “developing” – albeit one massive EM economy.
China is an enigma. For years now, it’s as though the Chinese could not get their money out of China fast enough. The outflows have been enormous – from fleeing crooks, to the rich seeking wealth-preservation, to those hoping to situate their children for a better life in the U.S, Canada, Australia or elsewhere. There is as well the spending for the estimated 100 million annual Chinese tourists clogging retail shops in major cities around the world. Up until recently, these persistent outflows were more than offset by inflows of unknown origin. For a while now I’ve assumed there was massive speculative finance flowing into China – “hot money” - enticed by higher yields and a pegged currency - that would some day reverse in a destabilizing manner.
The Chinese Bubble has caused a lot of damage – including repulsive air and water pollution. Society is further burdened by what has been historic inequitable wealth distribution. Chinese officials face a major challenge: they will need to print enormous quantities of “money” (to bolster faltering Bubbles) without inciting unmanageable outflows. I can imagine that finance is just flying out of the country right now. Perhaps Chinese officials actually believe a small devaluation will suffice. Others may see things differently. With Bubbles faltering, it’s time to get out.
For the Week:
The S&P500 increased 0.7% (up 1.6% y-t-d), and the Dow gained 0.6% (down 1.9%). The Utilities jumped 2.3% (down 0.4%). The Banks ended unchanged (up 5.4%), while the Broker/Dealers declined 0.8% (up 2.4%). The Transports recovered 0.8% (down 9.0%). The S&P 400 Midcaps added 0.9% (up 3.4%), and the small cap Russell 2000 increased 0.5% (up 0.7%). The Nasdaq100 added 0.2% (up 7.0%), and the Morgan Stanley High Tech index increased 0.7% (up 5.8%). The Semiconductors slipped 0.9% (down 8.1%). The Biotechs declined 0.8% (up 17.2%). With bullion recovering $21, the HUI gold index rallied 8.5% (down 29%).
Three-month Treasury bill rates ended the week at eight bps. Two-year government yields were unchanged at 0.72% (up 5bps y-t-d). Five-year T-note yields added three bps to 1.60% (down 5bps). Ten-year Treasury yields gained four bps to 2.20% (up 3bps). Long bond yields increased two bps to 2.84% (up 9bps).
Greek 10-year yields sank 208 bps to 9.25% (down 49bps y-t-d). Ten-year Portuguese yields slipped three bps to 2.40% (down 22bps). Italian 10-yr yields declined two bps to 1.81% (down 8bps). Spain's 10-year yields rose two bps to 2.00% (up 39bps). German bund were unchanged at 0.66% (up 12bps). French yields added two bps to 0.98% (up 15bps). The French to German 10-year bond spread widened two bps to 32 bps. U.K. 10-year gilt yields gained three bps to 1.88% (up 13bps).
Japan's Nikkei equities index declined 1.0% (up 17.6% y-t-d). Japanese 10-year "JGB" yields fell three bps to 0.38% (up 6bps y-t-d). The German DAX equities index sank 4.4% (up 12%). Spain's IBEX 35 equities index was hit 2.7% (up 5.8%). Italy's FTSE MIB index lost 1.9% (up 22.3%). Most EM equities markets were under pressure. Brazil's Bovespa index fell another 2.2% (down 5.0%). Mexico's Bolsa sank 2.5% (up 1.4%). South Korea's Kospi index fell 1.3% (up 3.5%). India’s Sensex equities index lost 0.6% (up 2.1%). China’s Shanghai Exchange rallied 5.9% (up 22.6%). Turkey's Borsa Istanbul National 100 index declined 1.4% (down 9.8%). Russia's MICEX equities index gained 1.3% (up 22.3%).
Junk funds this week saw outflows of $1.2 billion (from Lipper), the third straight week of significant negative flows.
Freddie Mac 30-year fixed mortgage rates rose three bps to 3.94% (up 7bps y-t-d). Fifteen-year rates increased four bps to 3.17% (up 2bps). One-year ARM rates jumped eight bps to 2.62% (up 22bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates down six bps to 4.04% (down 24bps).
Federal Reserve Credit last week expanded $2.5bn to $4.450 TN. Over the past year, Fed Credit inflated $73bn, or 1.7%. Fed Credit inflated $1.639 TN, or 58%, over the past 143 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt gained $6.0bn last week to $3.362 TN. "Custody holdings" were up $68.5bn y-t-d.
M2 (narrow) "money" supply added $1.8bn to a record $12.075 TN. "Narrow money" expanded $651bn, or 5.7%, over the past year. For the week, Currency increased $1.0bn. Total Checkable Deposits surged $87bn, while Savings Deposits dropped $87bn. Small Time Deposits increased $0.7bn. Retail Money Funds gained $1.4bn.
Money market fund assets gained $5.3bn to an almost five-month high $2.675 TN. Money Funds were down $58bn year-to-date, while gaining $97bn y-o-y (3.8%).
Total Commercial Paper fell $8.1bn to $1.059 TN. CP increased $51.4bn year-to-date.
August 13 – Wall Street Journal (Anjani Trivedi and Chao Deng): “The currencies of Asian emerging markets that trade heavily with China fell sharply after Beijing devalued its currency, as investors bet a weaker yuan will add to pressures on their deteriorating economies. Investors have pushed the currencies of South Korea and Malaysia down over 2% in the past two days, making them among the biggest losers globally since China devalued the yuan… Vietnam and Taiwan have engineered drops in their currencies. These nations’ exports to China are worth over 10% of their gross domestic product, making them dependent on Asia’s largest economy to fuel economic growth. While other countries that trade with China, like South Africa and Brazil, have seen their currencies decline in recent days, some of the biggest losses have been in Asia.”
The U.S. dollar index fell 1.0% to 96.57 (up 7.0% y-t-d). For the week on the upside, the Swedish krona increased 2.9%, the euro 1.3%, the British pound 1.0%, the Swiss franc 0.8%, the Brazilian real 0.7%, the Norwegian krone 0.6% and the Canadian dollar 0.3%. For the week on the downside, the South African rand declined 1.6%, the Mexican peso 1.3%, the New Zealand dollar 1.1%, the Australian dollar 0.5% and the Japanese yen 0.1%.