The New Big Short

The New Big Short

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On 22 March 2015, Christine Lagarde — the managing director of the International Monetary Fund (IMF) — made an important speech in Beijing. Madame Lagarde outlined the dangers of US Federal Reserve tightening for emerging markets. Her warning was stark:

‘The world has yet to achieve full economic recovery. Global growth continues to be weighed down by high debt, high unemployment and lacklustre investment…

‘The recovery remains fragile because of significant risks. One such risk emanates from the expected tightening…of US monetary policy at a time when many other countries are easing…

‘The divergence of monetary policy paths has already led to a significant strengthening of the US dollar. Emerging markets could be vulnerable, because many of their banks and companies have sharply increased their borrowing in dollars…

‘The potential spillovers would affect China mostly through its trade relationships with other emerging markets…Chinese exports would certainly be affected.’

Of course, we’ve warned readers about these dangers for months, but it’s always interesting when powerful international monetary elites confirm our analysis.

The problem is that Madame Lagarde has only addressed half the problem for China — the impact on trade. She has glossed over the more dangerous half of the problem — the impact on China’s debt.

The analysis is straightforward. The Federal Reserve has been flirting with tightening policy since Ben Bernanke’s May 2013 speech in which he introduced the idea of reducing, or ‘tapering’, Fed bond purchases.

This led to the infamous taper tantrum of May–July 2013 in which leveraged investors involved with the dollar carry trade dumped stocks and currencies in emerging markets and repaid dollar-denominated debt.

This was because Fed tapering meant that US interest rates would be going up. The Fed was warning those who were short dollars through borrowing to get out of the carry trade while there was still time. Many borrowers got the message and got out of the trade. But many did not.

Through late 2013 and all of 2014, the Fed did follow through with its tapering plans, but borrowers in emerging markets did not reduce their dollar debts. The problem now was not US-based leveraged traders, but the emerging-market borrowers themselves. They borrowed US dollars even though their central banks had no ability to print dollars — only the Fed can do that.

The result was what I call the ‘New Big Short’. Emerging-market borrowers are ‘short’ over US$9 trillion…with no ability to print.

A dangerous picture

Lagarde’s point was that when the Fed does raise rates, there will be enormous capital flight and financial distress in emerging markets around the world. This distress will hurt the ability of these countries to buy Chinese exports, which will have some negative impact on the Chinese economy.

That’s half right. Distress in emerging markets will hit Chinese exports. But Lagarde ignored the fact that China is itself an emerging market and has one of the most highly leveraged economies in the world, including the largest amount of dollar-denominated debt of any emerging-market borrower.

Here’s a chart showing the recent increase in private leverage in China:

When you add government leverage to private leverage, the picture is even more dangerous:

As the Fed prepares to raise rates, a dual crisis confronts China. Its export markets will dry up, exactly as Lagarde suggests, but it will also face a debt crisis.

Blind to the risks

China’s debt bubble is massive and includes both external dollar-denominated debt and internal local currency debt.

It includes everything from real estate loans and infrastructure bond issues to the Ponzi-like ‘wealth management products’ offered by banks and ‘shadow finance’ conducted by corrupt provincial officials.

This debt bubble is far bigger than what the US and the developed economies faced in 2007. A Fed rate increase now might be just what it takes to pop this bubble.

The problem is that Janet Yellen and other members of the Fed Board of Governors have not shown particular awareness of these dangers.

They are looking almost exclusively at the US economy, with very little concern shown for the rest of the world.

Many Western analysts treat China as if it were a normal developing economy, albeit much larger and more important than others. This is a mistake. China is far from normal. It is ruled centrally by the Communist Party of China.

Wall Street and Washington analysts tend to treat communism as an anachronism and say it is just a facade for what is rapidly becoming a more capitalist society. Nothing could be further from the truth.

Michael Auslin, writing in The Wall Street Journal on 29 January 2015, reported on an atmosphere of fear inside China with the ascension of its new ruler, Xi Jinping:

In just two years, Mr Xi has become the most powerful Chinese leader since at least Deng Xiaoping, and perhaps even since Mao Zedong. Some longtime experts talk about the possibility of something approaching one-man rule in Beijing, anathema since the excesses leading up to Mao’s death in 1976. Others argue that collective leadership is alive and well, but the party is indeed tightening its grip on Chinese society.

China’s supporters point to its US$4 trillion reserve position, mostly denominated in US dollars and consisting largely of US Treasury securities. This is indeed a source of strength that China can use to bail out its banks and douse the flames of any credit crisis.

But will they? Consider the consequences…

Between a rock and a hard place

If China has to dump US Treasury securities to deal with a crisis caused by a US rate increase, that will drive US interest rates higher, making the crisis even worse.

Many crises over the past 25 years, including the sterling crisis of 1992, the Mexican peso crisis of 1994 and the Asian-Russia financial crisis of 1997–98, have taught that once confidence is lost and a run on a central bank starts, no amount of reserves are enough to stop it.

The Chinese Communists will not go down without a fight. They will use every financial weapon in their arsenal to stem the coming debt crisis in China. These weapons include capital controls, selective defaults, asset freezes and currency wars.

[Editor’s Note: Currency wars are one of the most important dynamics in the global financial system today. Jim wrote about this at length years ago in his first book, Currency Wars. But what Jim didn’t mention then is that, if you know what you’re doing, you can profit handsomely from them. Click here to discover the best strategy you can use to survive the currency wars unscathed.]

China has already eased monetary policy three times in the past six months through a combination of interest rate cuts and reductions in required bank reserves. The Shanghai Stock Exchange is in bubble territory in the expectation of more monetary ease ahead.

Truly, China is between a rock and a hard place. If China maintains a strong currency, this will help its dollar debtors pay their debt, but it will hurt exporters and possibly pop the Shanghai stock bubble.

If China cheapens its currency, this will help exports and asset prices, but it makes the US dollar debt harder to pay.

On balance, China will probably maintain a strong yuan because they want to keep the IMF happy at a time when the yuan may join the IMF’s SDR basket as a global reserve currency. And it will put more stress on an overextended debt situation. This is a topic I will follow closely in my new investment advisory service, Jim Rickards’ Strategic Intelligence.

As for Chinese stocks, the best advice is to keep away. They may go higher on more monetary easing…but a bubble is still a bubble, and they always burst in the end.

Regards,

Jim Rickards,
for Money Morning

James G. Rickards is the strategist for Strategic Intelligence, the newest newsletter from Port Phillip Publishing. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He is the author of The New York Times bestsellers Currency Wars and The Death of Money. Jim also serves as Chief Economist for West Shore Group.

From the Port Phillip Publishing Library

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