The British Economy’s Achilles Heel Exposed

It sounds like a spy thriller. You’ve got money to get out of the country, tout suite! But where? How? You’re in a hurry. Quick! To the Spanish property market! Double quick! To the Portuguese property market.

I’m not making this up. ‘The yuan will keep depreciating as time goes by, so we should swap the money we have in hand into tangible assets.’ That was Li Xiaodong, the chairman of Canaan Capital, speaking to investors in Shanghai. Then he mentioned Iberian property. Does it make sense to you?

Think about it. You’re a wealthy Chinese businessman. Or you’re the owner of a business that’s invested in a Chinese factory. Or you moved money into the Chinese financial system because you thought the Chinese yuan was undervalued and you wanted to speculate on its inevitable rise.

But then, the authorities devalue the currency.

Source: StockCharts
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Now you want out. A lot of money wants out of China. Nearly $1 trillion left last year. Another $158 billion left in January. That trails only September of last year, when $194 billion headed for the exit after the first yuan devaluation.

The Shanghai Composite is back to its late August lows. But really, the ups and downs of the Chinese market are neither here nor there for British investors. They simply tell you the pace and intensity of capital flight. It’s picking up. But where’s it going?

One clue came from the latest Demographia study of the world’s most expensive housing. The group tracks a ratio of median house prices to median pre-tax household income. London came in eight at 8.5. One to seven went as follows: Hong Kong (19), Sydney (12.2), Vancouver (10.8), Auckland (9.7), Melbourne (9.7), San Jose (9.7) and San Francisco (9.7). The last two are mostly Silicon Valley stories.

It’s no coincidence all the cities on that list have seen booms in high-rise apartments sold, off-the-plan (with few questions asked) to investors from China. The Chinese have the money. A Sydney apartment is a lot more tangible than a bank deposit. And Bondi Beach is closer to Beijing than Barcelona.

How long will the Chinese capital exodus last? Where is ‘fair value’ for the yuan? And what should British investors do?

Sovereign debt depression
William White is the former head of the Bank for International Settlements. It’s the ‘central bank for central banks.’ White has credibility when it comes to financial warnings because he was one of the few officials who correctly warned of the dangerous build-up of debt in the global financial system in 2008.

He issued another warning last week. It’s sobering. Speaking to Ambrose Evans-Pritchard before the World Economic Forum in Davos began, White made the case that we may be worse off now than we were going into the last crisis. He said this:

The situation is worse than it was in 2007. Our macroeconomic ammunition to fight downturns is essentially all used up… Debts have continued to build up over the last eight years and they have reached such levels in every part of the world that they have become a potent cause for mischief… It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something… The only question is whether we are able to look reality in the eye and face what is coming in an orderly fashion, or whether it will be disorderly. Debt jubilees have been going on for 5,000 years, as far back as the Sumerians.

How soon is the next recession? In the UK, Mark Carney’s low interest rates, inflows of capital and the crashing oil price, have all contributed to 12 consecutive quarters of GDP growth. Carney projects that UK GDP will have grown by 0.5% in the fourth quarter of last year. But next?

That’s the big question. With oil low and inflation (other than house prices) hard to find, you’d be surprised if the Bank of England raises rates this year. There are simply too many other deflationary forces worldwide to justify higher UK rates now. Besides, the pound’s weakness against the dollar does some of Carney’s job for him.

But even that unexpected boon to exports won’t be enough to offset the kind of crisis White thinks could happen. If it does begin to happen in a disorderly fashion, whatever plans there are for a debt jubilee will be dusted off or made.

As an investor, you want to try and get ahead of this story before it happens. There’s a lot riding on the outcome, including the value of your portfolio (and by extension, the quality of your retirement).

Operation humiliate Britain
The coordinated scare campaign to bully Britain into staying in the European Union has begun. It’s an impressive coalition of Eurocrats, British politicians and multi-national banks. And to be fair, it’s possible to have a genuine disagreement on what’s best for Britain without being a villain. But there are some pretty good villains to choose from, if you’re looking.

At a forum in London, ‘Brexit’ was ‘war gamed’ to test different outcomes of the upcoming negotiation. Former Irish Prime Minister John Burton said ‘Brexit’ would be ‘an unfriendly act.

Then there was a thinly veiled threat to the City from former EU trade commissioner Karel de Gucht, who said, ‘How can you expect after leaving the European economy that that economy would accept its financial centre is outside its borders?

But it was former Polish deputy minister Leszek Balcerowicz who made it clear that ‘Brexit’ would trigger a punishing response by the EU. Britain would be made an example of to prevent ‘Brexit’ from giving any other countries ideas. The former deputy minister said:

We should not encourage other populist forces campaigning on exit such as National Front in France or Podemos in Spain. This is a very important consideration. This is in the interests of Europe that we do not encourage other EU countries to leave. The common interest of remaining members is to deter other exits. This should have an impact on the terms Britain gets.

Lord Stuart Rose, the former head of Marks and Spencer and the head of the Britain Stronger in Europe group, took a decidedly less provocative tone. It was still a bit of fear mongering. But it’s the kind of fear mongering we can all understand: it’s a risk when you trade the devil you know for the devil you don’t.

There are imperfections,’ he said, ‘but, by and large, [the EU] serves us well. What we don’t know is, what are we exchanging it for? The reality that we have got today against the risk of what we might not have tomorrow.

Can you quantify the risk of leaving? Will the Italians and the French steal business from the City? Will Britons living and working in Europe be forced to leave or to provide papers? Will companies based in the UK pack up shop and leave for the EU? It’s simple human nature to prefer the status quo unless you’re absolutely sure you’re trading it in for something better.

But have a look at what the original ballot looked like in 1975. Does that look like you were joining a European Court of Justice? Or ever closer union? A common currency? The end of national parliamentary sovereignty? It doesn’t look like that to me.

The EU took that consent and ran with it. They took more than they were given and ran further than anyone expected. And now, Britain is threatened with punishment if it doesn’t stay in a deal it never agreed to.

When the votes were counted after the last referendum they were clear. 17.3 million Britons, or 67% of those who voted, voted ‘Yes.’ Only 32% voted ‘No’. And of the 68 ‘counting areas’ in England (47), Scotland (12), Wales (8) and Northern Ireland (1), the ‘No’ vote had a majority in only two areas. Can you guess where they were?

In the Western Isles of Scotland, 70.5% of the voters said ‘No.’ In the Shetlands, it was 56.3% voting ‘No.’ Between them, they accounted for about 20,000 ‘No’ votes. Meanwhile, Britons could never have imagined the Common Market was always designed to be ‘ever closer political union.’

My prediction: ‘stay’ will win in a similar landslide this time around. Fear is a powerful emotion. The unknown scares people. And most people I’ve spoken to don’t see the referendum as a portfolio or pocket book issue. They see it as a political or immigration issue.

Dan Denning

Ed Note: This article was first published in Capital & Conflict.

Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

Money Morning Australia