Discover more from Campbell Ramble
Waiting for the crash. Waiting for inflation.
July 26th, 2019
As we have mentioned in the past, we believe the single biggest macro risk to the global economy is the precarious nature of the Chinese financial system.
For those that lend some credence to Modern Monetary Theory, one might be inclined to believe that the Chinese Debt Bubble will not create a Chinese Financial Crisis, as the vast majority of debt in china is denominated in domestic currency.
Those applying MMT to China are missing out on a key ingredient, the fact that the RMB remains essentially pegged to the dollar, and so while debt in China is notionally denominated in ‘domestic currency’, policymakers have essentially underwritten the value of that currency in the global reserve currency.
While steps taken over the past decade have opened up both the exchange rate and the capital account in China, the peg by and large remains, defended by the stock of assets accumulated during China's strong current account stage of development.
To the extent that the RMB is not the dollar, it stands to reason at some point policymakers will have to choose between exercising control over domestic monetary conditions, and the promise to maintain parity with the dollar.
ENTER BAOSHANG AND BANK OF JINZHOU
With the failure of Baoshang last month, and Bank of Jinzhou today, the writing on the wall for the shadowy elements of the Chinese financial system. There will be bank failures/resolutions, and there will be losses, though at the moment, nothing on the scale of western bankruptcies has been permitted.
Chinese policymakers, aware of the problem, have been putting mechanisms in place to expedite the inevitable restructuring of the financial system. Debt for Asset swaps, NPL securitization auctions, and organizing bank takeovers.
While the news about these moves have been pervasive, the actual use of these mechanisms pale in comparison to the scale of the underlying problem. As written in our work almost a year ago, much talk of deleveraging, without any real change.
As reserves slowly dwindle, the time for reform grows shorter and shorter. Policymakers play a dangerous game, supporting the perpetual motion machine through providing ample liquidity to insolvent lenders, while trying to force credit creation through the system to the parts of the economy that still have productive uses for capital.
Meanwhile, the scope and complexity of the problem metastasizes. WMPs and trusts have turned into DAMPS and TBRs and the market has slowly caught on to the game. Banks use non-loan channels to fund the extension of credit that would normally fail the bank loan sniff test, and in doing so, fund long term credit with short term liquidity. Intermediation of liquidity from good banks to bad banks via interbank lending, a classic game. Then a loan becomes a bond, the bond becomes an investment receivable, which allows a small regional lender like Baoshang bank to gobble up assets that normally would fall afoul of regulatory guidelines around risk, concentration and liquidity.
“Many interbank institutions might have blocked Bank of Jinzhou as a counterparty, which will likely wear the bank down. Regulators hope that the market keeps on doing business with Bank of Jinzhou and helps it pull through. So, currently they are discussing measures to resolve its liquidity problem,”
All of which begs the question, when does the music stop, and why?
We see the game as a simple application of the classical international monetary triliemma.
Independent monetary policy
A pegged (or managed) currency
A closed capital account.
Your move PBOC. Choose two.
What's interesting is that this occurring precisely at the moment that western economies suffer through the deflationary hangover from the 2008 crisis.
The Chinese credit bubble is not an independent phenomena, it has been supported, and extended, by the creation of liquidity in the west.
Thus, the sword of Damocles to the Chinese financial system is not domestic tightness, but tightness in the currencies she is pegged to: aka the dollar.
With the shift to easing in the west following the sell off in assets in 2H18, the PBOC has been given the gift of time.
Low / negative interest rates in the west, and the printing of money by developed world central banks lends the luxury of time to Chinese policymakers by a) limiting the scope of dollar appreciation (which would force the PBOC to choose between the peg and domestic liquidity provision) and b) generating excess liquidity in financial markets, some of which finds it's way to China in search of yield, balancing the persistent capital outflows from nationals trying to get ahead of the inevitable depreciation / confiscation of capital upon a banking crisis.
The market, addicted to central bank stimulus, has now given central bankers an ultimatum. Cut interest rates *multiple times* in the face of record high stock prices and record low unemployment, because…because we can.
Because there’s no inflation.
A level deeper, we see the ultimate enabler of this easing as being persistently low and stable inflation.
Were the trend in inflation to reverse, markets would be forced to price in higher nominal rates.
When inflation is 1% you can get away with nominal rates at 2% or 1%, but were it to rise to 3% even, then markets and central bankers would be forced to consider a world where nominal (and real) rates return to levels seen for 200 years (roughly 2.5% inflation and 2.5% real).
This would be a disaster for the asset classes and investment strategies that, following fed guidance and support, have moved radically out the risk and duration curve.
Not to mention popular (and well meaning) investment strategies that have convinced portfolio managers to add levered bonds and ever more illiquid private and venture equity to their portfolio.
It is this narrative which has convinced us at Black Snow that the return of inflation as being the single biggest risk to both western and eastern portfolios.
Inflation that would force central bankers to engage in actual tightening would seriously damage portfolios with too much duration and too little protection.
This tightening would then flow through to dollar strength, forcing the PBOC into a “Sophie's choice” between saving the financial system and keeping the peg.
It is with that in mind that we have renewed our research push to look across time and economic trends to better understand the causal drivers behind falling inflation. To understand if, and when, that trend will reverse, and with it the dominant narrative of the last fifty years of financial history.
We’ll keep you posted.