Bear in a China Shop

Photo: Wen-Chun Fan - CNN

It’s been a few months since I placed China firmly in my crosshairs. Since then, the evidence continues to portray a mind-boggling debt bubble, not only in the property and construction markets, but also in corporations financed by the shadow banking sector.

Initially, I thought the main problem was the property market but after realising how leveraged the corporate sector is, my attention turned to the copper, coal and iron industries with connections to the shadow banking system. My updated thesis is that the overleveraged corporates (specifically the coal mining, iron ore, copper, cement and property industries) will be the first to crack causing defaults in the shadow banking system. Loan defaults inevitably lead to tighter credit conditions and further defaults, falling asset prices and collateral impairment. The vicious cycle is complete and suddenly the economy is in free-fall.

There is no question in my mind that the defaults will occur but what will the policy response be? The Chinese government will respond with bailouts, debt guarantees and more fiscal stimulus. Despite the financial firepower that Beijing has, the scale of the problem is so vast that it will overwhelm the economy before Beijing reacts.

But let’s say that Beijing is successful in preventing a few defaults initially. The distortion of risk will perversely cause investors and speculators to pump more funds into bad investment products as any losses incurred will be recovered via a bailout (increasing moral hazard).

The main catalysts for the China collapse in order of most likely to least likely are:

• Government inaction (no bailouts) that results in tighter credit conditions or intervention to deliberately depreciate the Yuan (reversing leveraged carry trades)

• Falling commodity prices causing collateral impairment, forcing collateral liquidation which causes further falls in commodities in a self-reinforcing cycle

• Defaults relating to property market speculation occur causing a downturn in the economy and falling demand for commodities

In this post I will provide evidence for the aforementioned conclusions. You can decide for yourself if this is just doomsday permabear talk or if China is on the precipice of the abyss.

Chinese banks and bad loans

The borrowing binge of the last couple of years has seen a rise in Non-Performing Loans (NPLs) for the largest Chinese banks. Beijing has tried to clamp down on the leveraged banking sector and the reports of rising NPLs is seen as a pre-emptive move to mitigate a future surge in NPL ratios amid rising defaults in 2014.

This raises suspicions that if the largest banks are reporting rising NPLs, one can only imagine the amount of bad loans in the opaque shadow banking sector. To illustrate the relative size of the shadow banking sector, the five largest state owned banks and the 12 largest national lenders control more than 60% of China’s banking assets with other financial institutions owning the rest. There is cause for concern with NPLs rose by 28.5bn Yuan in last quarter of 2013.

NPL ratio rising since Q3 2011 (time axis reversed)

Despite the worrying trend in NPLs, this has not dampened confidence in lending. In fact, total social financing increased by the largest amount in history:

Credit boom continues

Shadow banking

At the heart of the excessive credit is the shadow banking system in China. Essentially, the shadow banking system refers to the unregulated financial intermediaries and the investment trust products they produce. These trust assets are marketed as “wealth management products” (WMPs). A good analogy for WMPs is the mortgage backed securities that went bust during the GFC. But instead of institutions buying these products, it is small retail investors and instead of mortgages backing these trusts, it is loans to corporations and local governments. The growth in these trust assets and WMPs have been enormous to say the least, with growth in the last few years averaging 40%p.a.

Trust asset boom is unsustainable

Bailouts and moral hazard

One of the counterpoints put forward by the China bulls is that the government can just expand credit and bail everyone out. Unfortunately this creates huge moral hazard and encourages reckless risk taking throughout the entire system.

Wealth management Products (WMPs) offering double digit returns are presumed by investors as being guaranteed by the issuers. Avoiding the default has misleadingly confirmed that presumption leading to that perennial distortion of risk… Ye Olde Moral Hazard.

In a JPM report they conclude, “Avoiding defaults will only delay or even amplify the problem in the future.” Get ready for the first wave because in the short-term there are a large volume of WMPs maturing which poses substantial rollover risk.

To summarise, bailing out losing trust products creates moral hazard and exacerbates the risk of further volatility. The lack of perceived risk will entice further investment, further inflating the bubble and worsening the inevitable crash.

Chinese commodity collateralised loans

While the central government is aware of the accumulation of leverage in the system, the crackdown on lending has driven companies to use raw commodities such as iron ore, copper and coal as collateral. These schemes increase the risk on loans by exposing lenders to a fall in commodity prices which will impair collateral. This creates the dual risk of either loan defaults causing collateral to be liquidated or commodity prices falling first and the value of collateral being insufficient, leading to lenders calling for more collateral.

Given the above, the record build-up of iron ore inventory at Chinese ports is a worrying sign and could precipitate a collapse in commodity prices:

Inventory piling up and does not bode well for prices
Source: Unknown

Already iron ore prices are declining as inventory is at all-time highs. Adding to the pessimism is falling industrial demand and speculative activities by commodity traders. There is anecdotal evidence that commodity importers have been using their inventories as collateral to bet on Yuan appreciation. Some have even borrowed dollars, converted them to Yuan and invested the money in “high yielding” accounts.

Iron ore prices at new monthly lows
Source: Barchart

From SoberLook, “With banks cutting back lending to this sector and the recent decline in the Yuan, traders are being forced to dump inventory and that is sending prices lower and causing some mills to close. All of this points to tighter credit, weaker demand and slower industrial activity going forward.”

China upcoming trust defaults

There have already been reports by the media of potential trust defaults. The upcoming trust defaults seem to be concentrated in Shanxi province and in the coal mining industry. Repayments may be extended to avoid default in the near term and Coal mine trusts are most likely to default because coal price has fallen recently.

The maturity wall is fast approaching

Chinese housing market

Residential property in China’s 70 largest cities is also coming off the boil. It is still early days but if the fall in property prices gain momentum, this will dampen the speculative frenzy. A rapidly cooling property market and falling coal and iron ore prices will compound the contraction in credit growth as trust products default.

Chinese households have invested vast amounts in property and are now massively exposed to a housing bubble. China housing prices have increased substantially with households holding on average 65% of their assets in real estate and 90% of households already owning a home. Supply is coming to market at a rate of 15mil new units per year.

Chinese house prices in a speculative fervour

Impact on the world

I remember watching an episode of NCIS and the veteran detective saying, “I don’t believe in coincidence.” There is a link between Chinese capital flows and the US Federal Reserve’s QE program. We have seen the effect QE tapering on emerging markets (EMs) as the carry trade unwinds. Tapering will speed up the withdrawal of capital causing financial conditions in China to tighten. This is relevant because the Chinese trust sector is partly financed overseas. Low global rates and expectations of perpetual Yuan appreciation have resulted in higher investment returns promised by trusts. Part of the debt raised overseas is probably invested in the trust carry trade. Hong Kong banks are big participants and if China goes bust, you can expect the Hong Kong banking system and property prices to come under pressure.

Honk Kong financials are heavily exposed to Chinese borrowers

BAML says if China blows up there will be safe haven bids for developed market (DM) government bonds, overseas property and precious metals. One of their alleged smartest clients said, “The main theme in the past 5 years was QE. If that is coming to an end, investments and themes that worked in the past five years must therefore be questioned.” This is an important reminder about the immense global implications of any crisis given China’s contribution to world economic activity.

Yuan leveraged bets

The “managed economy” that China espouses has resulted in massive speculation in property, commodities and of course the currency. China has steadily allowed the Yuan to rise and has gradually allowed increasing volatility over the years. Corporations have taken out derivatives known as target redemption forward contracts to bet on the increasing currency in what many have described as the “easy money, no risk, no brainer” trade. Unfortunately, the government has ended the party in recent weeks with the Yuan depreciating significantly during a short period of time. While in absolute terms the move is not dramatic, it does cause the problem of huge losses for corporates who are exposed to these leveraged derivatives.

To summarise the problem, the longer the currency depreciates the more losses are sustained. Even if the currency remains below certain loss thresholds, collateral or margin calls will be used to reduce the risk of positions for banks. This means corporates will have less cash and will become more leveraged. You can read in more detail about the derivatives here.

Arguments against a China collapse

Another argument against a major crisis is that China runs a“non-commercial” financial system, that there is no counterparty risk since it’s just one giant state run labyrinth and bailouts will flow at the first sign of trouble.

Such a system is not immune to shocks and is in fact more fragile and more susceptible to adverse events. I have already mentioned that avoiding losses will result in moral hazard and lead to more risk taking and leverage. Eventually the boom will become too inflationary (as seen in 20%YoY property price increases) and they will be forced to tighten, which then causes tighter credit and eventually defaults that further destabilise the system.

The “China is immune view” also emphasises that market forces deal with problems and governments do not. Loss making decisions are eventually purged from the market, while they are perpetuated and exacerbated in a government controlled system.

Picking the top in the market

There’s that old adage in the investing world that the markets can remain irrational longer than you can remain solvent. This is especially true for bearish investors and traders calling the top in any bubble. I have previously said I expect Australia to be in recession before 2016 based on many risks including a Chinese financial crisis. That is still my base case. In making this prediction, I am committing the cardinal sin of picking the top of the market or trying to time the collapse. Jim Chanos (runs a short-selling hedge fund) has been predicting the Chinese collapse since 2009 and five years later it still has not happened! I am happy to be wrong on timing the crash because I am convinced that it will happen given all the facts listed above.

Conclusion - warning signs

We all know that inflationary debt bubbles burst eventually because central banks and governments understand the instability caused by rampant leverage and speculation. By then it is too late, and the economy must undergo a remedial recession to purge the malinvestments.

China’s highly leveraged economy has numerous risks that would trigger a chain reaction throughout the entire system. The property market, the commodity market, the currency market, the banking system and leverage corporations form a powder keg that will soon find a spark.

When someone says, “China is immune”. What I hear them saying is, “this time it’s different”. The same denials you hear when history has proven that credit fuelled bubbles never last. You will always hear the same bubble mantras that defy logic like, “property prices never go down” (US sub-prime 2007), “earnings don’t matter” (Tech boom 2000), “they have a super-productive economy and are different” (Japan 1990) etc. When central planning and debt is involved, nothing ever changes and you can expect history to repeat again and again and again.

Source

How a Currency Dies

India is a prime example of a broken country and squandered potential. Years of mismanagement and interference has mutilated an economy which is now disintegrating before our eyes.

The fires of inflation destroy purchasing power

The volatility over the last year in Indian financial markets resulted from years of government monetary intervention and bureaucracy choking productive activity. In this post I want to explore the causes of dramatic currency depreciation and possible remedies.

Burning Down the House

Firstly, we have to look at how this happened. India was part of the infamous BRIC nations. Supposedly, India was a new engine of global economic growth that would unleash millions of middle-class consumers demanding more goods and services from the rest of the world. China was the poster child and India was its little brother waiting for its chance to live up to the high expectations set by its sibling. But as any free market or Austrian economist will tell you, economic growth can only occur when there is less government involvement in the economy.

Fundamentally, India has not escaped its historical communist influences. The government is strangling the private sector with a byzantine regulatory system, numerous taxes and a corrupt bureaucracy. The political actions of recent weeks epitomise the intrusive and destructive handling of the economy. By placing restrictions on gold imports and then banning currency derivatives resulted in greater capital flight and a greater loss of confidence. This then leads to a vicious cycle of more regulations and more capital flight until the government and society capitulate to reality.

A depreciating currency is always caused by loose monetary policy. Interest rates are kept too low, resulting in excess credit creation and eventually rising prices. Unless interest rates are raised to quash rising prices, the currency loses its integrity as a store of value. People quickly convert the depreciating currency into commodities (e.g. precious metals), hard assets and alternative currencies to avoid the loss of purchasing power. At some point, the government is forced to act correctly as social tension rises amidst a financial and economic crisis. If the government denies its prior economic mistakes and maintains loose monetary policy, hyperinflation and a complete loss of confidence is the inevitable conclusion followed by transition to a new currency. We have seen this throughout history and thus none of this is a revelation; it is the certain truth.

Eye-Watering Results

To give you an idea of the extent to which the Rupee has lost purchasing power, we will look at a staple of the Indian diet, onions. As seen in the chart below, onion output and productivity has dramatically increased and is a testament to India’s agricultural industry harnessing better farming techniques and utilising capital.

In a free market economy, such a large increase in onion production would result in lower prices but guess what prices have done:

This is exactly why Indians have an insatiable appetite for gold. Gold has always been a part of Indian culture and has become more sought after due to the realisation that gold is a better store of value than the Rupee.

Behind the Curve

When exactly did the Reserve Bank of India (RBI) commit the crime of inflating the money supply? At the same time most central banks did, in the aftermath of the global financial crisis of 2008/2009. Below is a graph showing the changes in the consumer price index which measures the average prices (dashed red line) in the economy compared to the interest rate set by the RBI (solid black line).

Before 2009, the CPI was slightly below the interest rate which means the cost of borrowing was very low. After 2009, the RBI slashed interest rates but made the fatal mistake of raising rates too slowly. During 2010, the CPI was increasing at 8-10% p.a. while interest rates were below 6% and slowly rising. Real interest rates were negative, which meant credit had no cost and resulted in a booming property and stock market. This attracted foreign capital as interest rates around the developed world were at or close to zero. There was a huge yield differential that could be exploited via borrowing in the US at a low rate and then investing in India at a higher rate. This caused upward pressure on the Indian Rupee as portfolio flows flooded Indian capital markets (bonds and stocks). Portfolio flows (equities, bonds etc.) were favoured over foreign direct investment (building factories, buying entire businesses etc.) because of India’s hostile business environment which made it easy and less risky to buy equity and debt in companies.

India is just the worst case out of all emerging markets. A few years ago, emerging markets joined the currency war. They were complaining about QE because it was causing all this hot money to flow into their economies. But instead of allowing their currencies to rise which would have ended the inflows. They bought USDs and US treasuries and sold their domestic currency to stop it appreciating. Now that USDs are being repatriated from emerging markets, their domestic currency has come flooding back.

Similarly in India’s case, what goes up must come down. The Fed’s rhetoric changed in late May with hints that asset purchases will taper. This sent a shockwave around the world as US treasury yields rose, narrowing the yield differential between the US and economies with higher interest rates. The Australian dollar was one currency that depreciated as the RBA cut interest rates. Likewise, other Asian and emerging market economies saw their currencies tumble. As the situation unfolded, the market became aware of the precarious position India was in and panic took over. But what can India do to stop the Rupee depreciation?

Do It! Do It Now!!!

Things India can do to turn the tide:

• Sell all foreign currency reserves (US$275bn) and gold (US$25bn) to buy rupees. Then destroy the purchased Rupees. The effect is a reduction in the Rupee money supply which will have an immediate impact on the exchange rate. It also sends a message to the market that the government is serious about a strong Rupee
•  Raise interest rates to squash inflation. There’s no balance between growth and inflation. The only way to get India growing again is to liquidate bad investments and rebuild after the recession has reset the economy. This is what Regan and Thatcher did in the 1980s.
• Fully deregulate the domestic economy. This will encourage long-term foreign direct investment instead of portfolio capital which can leave the country quickly
•  Reduce government spending to balance the budget. A good place to start is defence with India being the largest arms buyer in the world. By reducing the deficit, the government borrows less money from the private sector and therefore the private sector has more capital to invest in productive investments. A submarine is not a productive investment!

However, Indian elections are around the corner and reform measures are not popular. This is what happens if no reforms take place:

•  Rupee continues to plunge, which results in lower confidence and capital flight. Could result in a vicious cycle till the government is forced to act
• Import prices sky-rocket. Oil is already 50% more expensive in recent months
•  Long-term stigma and sovereign risk due to the perception of a dysfunctional economy

The only way India can seize its potential is by deregulating the entire economy and restoring faith in its fiat currency as a store of value. Both these actions are difficult given their political implications, which is why I am doubtful they will be done voluntarily. It will be the market who makes an offer they can’t refuse, and will be the driving factor behind change. Unfortunately, this episode has proven once again that the actions of the few in government torture the many living under India’s rule.

Apocalypse Now

This blog update will focus on the main risks I see on the horizon for the Australian economy.

I warn you that I haven’t really bothered to format and edit it, so I apologise in advance if it’s difficult to read.

I will start off with the simple premise: All booms come to an end. The Japanese boom of 80s and 90s, the 1994 Tequila crisis, 1997 Asian financial crisis, the 2001 tech boom, the 2007 US housing boom and in 2013 the China boom. All of these eras culminated in major increases in asset and commodity prices, usually accompanied by debt, until central banks removed the punchbowl through contractionary monetary policy.

A Bear in a China Shop

Australia is a major beneficiary of the Chinese boom by supplying the energy and minerals needed to fuel China’s economic activity. China’s rapid industrialisation has resulted in many malinvestments, which will be liquidated as capital flows dry up. The excess capacity and debt accumulated during the boom will haunt the economy for years to come. It is generally accepted that the bigger the boom, the bigger the bust.

The Chinese banking system has also been dysfunctional in recent weeks with SHIBOR spiking as banks face liquidity problems. This is a microcosm of the systemic imbalances and instability plaguing China. It’s only a matter of time before a tiny bump in the road crashes the economy.

Falling iron ore, copper and coal prices will be the harbinger heralding the beginning of the end for the Australian mining sector. The government will stimulate as usual but just like in 2009, it was the currency devaluation and the stimulus from China that did most of the heavy lifting.

Big in Japan

Japan is rolling the dice with its audacious monetary policy. The volatility seen in JGBs will have consequences for institutions that are sensitive to high volatility investments. I know this from experience that banks look for positive carry and low volatility assets. JGBs are likely to sell-off given higher future prices from today’s QE. (Funny how a few years ago if you said QE causes inflation, you were ridiculed). Like all government actions, the unintended consequences will be largely unknown. However, it is certain to cause massive market disruption as long-held beliefs are shattered.

If JGB yields rise significantly then the consequence for the Japanese government’s budget is dire. This is what Kyle Bass refers to as the Keynesian Endgame which is when the interest cost of servicing the debt rises in a non-linear way which means simply increasing taxes will be ineffective. Then it will be Japan’s turn to experience its own Greek moment, however there’s no Troika to bailout Japan. Inevitably, the social fabric of Japan will be torn and the historical outcome of mass social unrest is the rise of extreme politics (See Greece and Golden Dawn, see Weimar Germany and the Nazi Party) followed by conflict and war.

Everybody was Kung Fu Fighting

Chinese and Japanese economic risks are not the only factors but also geopolitical risk stemming from conflict over the Senkaku Islands. Both sides are irrationally attached to these islands and are willing to go to war to seize control. If there were a conflict, it would first result in economic sanctions between the warring nations followed by armed conflict unless the UN intervenes to negotiate a cease fire. The impact on financial markets would be huge with the yen likely to rally substantially in risk-off flows bringing an abrupt end to Abenomics. Equities are guaranteed to sell-off. It would be hard to imagine any rallying (maybe domestic producers) but with so much of the global supply chain located in Asia, most multinational companies will face major disruptions.

Up the Creek

In addition to foreign risks, domestic risks are a slow grind lower in property prices as the boom over the last few decades ends, and the factoid of property prices rising forever is rejected.

There are also known unknowns (as Donald Rumsfeld likes to say), which include terrorism, global health pandemic (watch the movie Contagion), natural disasters, wars, government policies (QE, protectionist trade and capital policies). Individually they are unlikely to occur but collectively one of these happens every 3 years (Swine/Bird flu, Fukushima, QE, Boston bombings).

Of course it’s not all doom and gloom. There are a few unlikely upside risks which include: New technological development that makes Australia a world leader, major resource discovery, massive Chinese economic stimulus. This is the Bon Jovi equivalent of living on a prayer. 

The fundamental problem with the Australian economy, along with most advanced economies, is the heavy debt burden which must be alleviated through deleveraging or defaults. Just think about it like this: It’s 2009 and interest rates are at record lows. John decides to buy a $500k house to take advantage of the low interest rates. This means upwards of $400k in new money (expanding the money supply) has entered the economy courtesy of fractional reserve banking when the mortgage is originated. It’s now 2013 and interest rates are coming down. Joe can now repay his loan faster (contracting the money supply) or use the money saved in interest payments for other consumption purposes. The key point is unless new loans are being originated, falling interest rates have a diminishing effect on monetary expansion given it was only 4 years ago that people took out massive loans which they are still repaying.

This causes the economy to deleverage which means businesses go bust, unemployment rises and prices fall. All of these outcomes force the RBA to cut interest rates to ignite another cycle of inflationary monetary expansion and the illusion of economic growth. Keep in mind we haven’t had a technical recession (two consecutive quarters of negative economic growth) in over two decades. We are due for a recession because markets and economies NEVER move up in a straight line. There are dips along the way and the longer we postpone the recession, the deeper it will be.

Breaking Windows Will Boost GDP

Already we have seen the fallacy of stimulus spending. The moment we try to pay back the debt, jobs are destroyed through contractionary fiscal policy (less spending or higher taxes). This means when the next recession comes, the government will go deeper into debt. On average, recessions occur every 7-10 years which means we should expect an Australian recession between 2015-2018 using historical data. However, given the inability of the RBA to raise rates substantially before the economy begins to deleverage (as seen post 2009), the business cycle is contracting in duration. So much so that I am sure a recession will come before 2016. Obviously the government will try to stimulate and rates will be cut closer and closer to zero.

As a personal anecdote, I know financially unsophisticated boomers who bought their homes a few decades ago that are now cashing out their investment properties and living off term-deposits. This is exactly why interest rates continue to fall. The economy is trying to delevereage which means property prices and other assets will decline while the RBA tries to push prices back up to avert pessimism overcoming the property market.

There is a theory that claims the closer rates go to zero, the more risk averse investors become and the more they invest in government bonds and other relatively low risk investments. This theory is only true for advanced economies with an ageing population such as Australia.

Forecast: Cloudy With a Chance of Thunder Storms

My predictions: base case rates go lower in Australia to 2% and in combination with the lower AUD (70c-80c) causes the economy to re-leverage. Worst case scenario is an implosion in Asia due to any of the factors mentioned above, will cause rates to go to zero in Australia and the AUD to go sub 50c as commodity prices collapse and the high unemployment prevents credit growth from occurring.  It’s difficult to see any bullish scenario simply because “we’ve been there and done that” for a few years now.

The obvious plays for a long-term investor in a falling interest rate environment are defensive stocks and high dividend yield stocks. But a safer option would be corporate bonds that would still offer a decent yield while central bank rates approach zero. If you want to trade it then the obvious trade is shorting AUD against a reserve currency like the USD or EUR. Or a safer currency trade would be short AUD against another commodity currency less affected by China such as the NOK (Norway). Other trades include shorting high cost iron ore miners which will see their businesses go under overnight as commodity prices plunge.

Anyway I hate predicting anything financial or economic more than one year out because there are so many variables that could throw a spanner in the works. It will be amusing to see how it plays out compared to the aforementioned predictions.

Summary of Predictions

• Australian recession before 2016
• Interest rates to go to 2% and AUD/USD 0.80-0.70 base case with rates going to zero and AUD/USD below 0.50 worst case (financial/political crisis in Asia or global macro risk mentioned above)
• Corporate bonds to outperform, short AUD and iron ore miners trades to also outperform

“I don’t get paid to be an optimist or a pessimist. I get paid to be a realist.”

The Keynesian Endgame

I absolutely despise the Keynesian school of economic thought. The Keynesians worship three gods: demand, jobs and inflation. All of which have given us the world that we live in today. A world mired in debt due to government policies designed to stimulate demand and “create” jobs. The parabolic rise in debt across the economy since the 1970s cannot go on forever. It should be obvious to anyone that anything rising at an exponential rate will eventually hit a constraint that will reverse the trend.

The constraint to hit parabolic debt is deflation. Deflation is a contraction in the money supply. Most people will say deflation is falling prices but changes in the price level are a consequence of the supply of money relative to the goods and services produced in an economy.

During the boom times, economic activity is rising and money is being borrowed. Fractional reserve banking creates a vicious cycle of rising asset prices, followed by rising levels of equity relative to debt, further leading to more money borrowed which is then used to bid asset prices higher. Eventually, this cycle is reversed as central banks increase interest rates to a point where asset prices stop rising and debts are repaid or defaulted upon. What follows is a cycle of falling asset prices and as debt is repaid, a contraction of the money supply (deflation). Central banks (CB) see this as a major problem which is solved by slashing interest rates to get people borrowing and see rising asset prices. Before you say this is crazy talk, Bernanke has explicitly said the Federal Reserve has propped up not only the housing market but the stock market in what he calls “the wealth effect”. Every major central bank has this secret third mandate of propping up both housing and the stock market (the first two are inflation and employment). It was only a few years ago that no central banker would admit to having this secret third mandate.

This model of monetary policy has worked “fine” until the demand for new borrowing evaporates and despite interest rates being cut, the economy does not return to the debt fuelled inflation boom. This is my theory of the economic cycle, which closely resembles Austrian Business Cycle Theory and it may even be the same. Eventually debt becomes too high and no matter what the CB does the deleveraging process continues.

Either the government slowly tries to reflate the economy (Japan last 20 years) or they go nuclear with continuous debt monetisation (US Federal Reserve) or threats to go all in (Bank of Japan in recent months) with seemingly outlandish policy options such as negative interest rates, nominal GDP targeting and monetising private sector assets (corporate bonds, equities etc.).

With central banks increasing underestimating the risk of rampant inflation as a consequence of their unconventional monetary policy (debt and asset monetisation), the inevitable conclusion is hyperinflation. CBs have made it clear they will not tolerate deflation. Nothing is stopping them from expanding the money supply by trillions as long as they fear the threat of deflation. This is exactly why asset prices will skyrocket and the only thing likely to destroy confidence and asset prices are an exogenous shock (natural disasters, political risks, terrorist attacks, wars, social unrest etc.).

The consequence is rising interest rates as investors realise the CBs have poured gasoline on the fire through their reckless monetary inflation. Bond markets will collapse and anyone holding long duration debt will be burned (insurance companies, banks and pension/superannuation funds). Government borrowing costs will rocket higher as rising interest rates will mean any debt that is rolled over will rollover at higher interest rates. This is very similar to the sub-prime mortgages crisis when low teaser interest rates made the mortgage affordable until the interest rate reset to a much higher rate a few years later. This will result in the government slashing government expenditure in an attempt to service the debt and appease the bond vigilantes. The current European debt crisis is a glimpse of what we can expect when governments have to make tough decisions that are very politically unpopular.

The penultimate result of the chaos will be a deep recession as unemployment rises, causing social unrest (riots and protests) as governments struggle to deal with the problem (see Greece and Spain).

Central banks will be forced to increase interest rates but I guarantee they will be too slow to act or worse remain in denial and downplay the inflation risk as “transitory”. The UK has already experienced the effects of monetisation on consumer prices.

What’s worse is there are now calls in the UK to drop inflation targeting in favour of nominal GDP targeting. This essentially means if the nominal GDP target is 4%, inflation can be 3% which means real GDP is only 1%. Another combination is a target of 3%, real GDP of -2% and inflation of 5%. There are numerous permutations but it just shows how ridiculous nominal GDP targeting is.

What is the solution? Over the years I’ve realised it’s usually the politically unpopular decision that is the correct decision. The only way we can address the debt issues not only on the public balance sheet but also the private balance sheet is to embrace sound money and back currency with gold or at the very least some other commodity. This stops the limitless expansions of the money supply and links it to a steady growth rate. There will be pain initially as people realise of the features of a gold backed currency is an end to the continual debasement and the end of rising prices economy wide.  

This solution is unlikely to happen because firstly, the mainstream pundits support the current monetary system and secondly, moving to a gold backed currency will be politically unpopular as vested interests scream and shout in protest (banks will probably the most vocal opponents given their mortgages denominated in the old currency and because the new system limits their ability to lend).

It will usually take a crisis to change people’s perceptions but even then, there’s no guarantee that perceptions will change for the better. I will strongly support the minority that adopts the new system first because it will take the minority view becoming the majority view before we see real change for the better.

Banks Feed Off Inflation

Firstly let’s define inflation. Today’s common usage refers to inflation as rising prices either caused by an increase in aggregate demand with aggregate supply remaining static (demand pull inflation) or a decrease in aggregate supply while aggregate demand remains constant (cost push inflation).

So if there are tax cuts and there is more demand for all goods, is this considered inflationary? Yes by modern definition there will be an increase in aggregate demand causing demand pull inflation.

But my own view of inflation/deflation is the same as the classical definition of inflation which is an expansion of the money supply. The symptom of inflation is rising prices, which is why over time the factoid equating inflation to rising prices exists.

When the central bank adjusts interest rates, this affects the money held in bank reserve accounts and in turn affects a bank’s ability to make loans and increase the money supply.

When banks originate loans the money supply expands since a 10% reserve requirement will lead to banks using a $100 deposit to create a $1000 loan. This means when borrowers repay loans, the money supply contracts and similarly if a borrow defaults, the money supply really contracts. However, banks will use buffers to protect themselves against a default by first making sure the borrower is credit worthy, then requiring a deposit to banks are not taking the full risk, finally collateral will be linked to the loan (e.g. the property will be collateral for the mortgage loan).

As the money supply expands (inflation), asset prices rise since there is now more money chasing the same amount of goods. This in turn increases the demand for loans since people see asset prices rising and believe the economy is growing and additionally collateral value increases allowing potential borrowers to increase the leverage on their loan. Loan serviceability is another important factor when banks assess a potential borrower. Since all prices are increasing, including wages, pretty much all the factors a bank will look at to originate a loan improve in favour of the borrower.

This is the inflationary cycle that causes borrowing to lead to higher asset prices and then more borrowing. The central bank then tries to control this by increasing interest rates which should decrease the demand for new loans. However, there is a time delay in the effect and because the bulk of loans are long-term in nature (longer than a year) the economy doesn’t feel the full effect of a string of interest rate rises until a few years into the future. Eventually the economy begins to contract after a string of interest rate rises result in a fall in borrowing and then it is up to the central bank to re-start the game by slashing interest rates to begin a new cycle of borrowing and rising asset prices. This is how the business cycle works and is why under the current system any deflation is considered bad because if the central banks leaves the economy to contract and allow deflation to take hold, it will continue unabated until prices are so low that demand for loans increases. This could lead to a substantial contraction in the money supply and prices falling more than 10% in a single year.

The problem with this system is that banks depend on inflation the resulting loan origination to increase and maintain their current profits. If there is deflation, people demand less loans and repay their loans faster to reduce debt burdens. This causes a huge contraction in bank profits and when the economy really contracts, collateral values plunge as a vicious cycle of loan defaults and collateral devaluation takes place. One only has to look at what happens when a country has a bubble economy to see this scenario play out. Japan in the early 1990s, the US in 2008 and soon Australia will have its day of debt deflation.

Australia has hitched its wagon to the Chinese growth engine and Asia in general, which is where I fear the economic shock is likely to manifest itself. In many financial and economic crises we see banks come under severe stress and in many cases collapse as their reserves vanish via asset impairment, exposing their leveraged business model. Governments then become involved via bailouts and hence taxpayers are now proud owners of zombie banks.

This is exactly why substantial deflation (>2% deflation) will never be allowed to occur and why eventually rates will go to zero. Banks will not survive unless they dramatically increase their reserves, which I do not foresee happening during extreme economic uncertainty. The government will nationalise banks claiming that the economy will implode if nothing is done.

These are dire predictions and I am sure the majority will disagree with this forecast but is there really another outcome when the current solution to any downturn is to spur spending and borrowing via lower interest rates?

We Want a Stronger Currency!

I wanted to write a timely article on the effects of a strong currency. We are currently seeing the Australian Dollar (AUD) rise to lifetime record highs against the Euro as problems in the Eurozone continue to fester and investors look for perceived safe haven economies to park their money. The Australian economy is a very attractive location for capital because of its stable developed economy, stable political system, relatively low government debt and is generally business friendly.

Safe haven status takes years to attain but can be lost in few months. The most recent currency to lose some of their safe haven credibility is Switzerland, which pegged its currency to the Euro and now has to print unlimited amounts of Swiss Francs (CHF) to maintain the currency peg. Since the Eurozone fears lead people to buy CHFs, the Swiss are forced to increase their money supply to meet demand, which will eventually cause prices to rise as those newly created CHFs leak into the wider economy.

The economic pundits will tell you that the high AUD or CHF is hurting domestic industries and jobs are being lost. This fails to recognise that the fundamental goal for an economy is not to have more jobs but to increase productivity. Maybe every Swiss person could have worked for 35hrs a week instead of 40hrs a week since their purchasing power is increasing in EUR terms. That’s obviously a good thing and helps them achieve a higher standard of living by making their lives easier and more enjoyable to live.

The Swiss government fell for the myth that a weak currency stimulates exports. But what they continually forget to mention is the reduced cost of imports that benefits EVERYONE in Switzerland. There will be changes that will occur in an economy with a strong currency including job losses since marginally productive exporters will face greater competition through cheaper imports. Some businesses will close down but others will become more productive. The business that closes down will result in job losses but does that mean the newly unemployed will never work again? OF COURSE NOT! There is always a productive use for labour in an economy and as long as wages and labour regulations are flexible, the unemployed will find work elsewhere within the economy. Maybe new employment opportunities will come from a growing business reliant on imports that have seen demand rise as their products are now cheaper. The net result is an increase in the overall productivity of the economy and is an example of Schumpeter’s creative destruction, where the resources from a non-productive business are reallocated to a more productive business.

The other point touched on before was that a stronger currency will benefit everyone since they can buy goods from the rest of the world cheaply. Exporters may see stiffer competition but they too will see costs decline if they import supplies or raw materials from foreign businesses.

The Australian economy is a great example of an economy that has thrived despite seeing a rising currency. This does not mean the economy is completely healthy because households continue to have high debt levels due to large mortgages and we are likely to see the property market continue its slow decline. Australia is also heavily exposed to Asia and if there is a slow down or financial crisis our economy could be slammed. But things continue to function and we have not seen our economy die as a result of the strong Australian dollar. Next time you see the Aussie dollar make a new high, don’t frown, fist pump the air and shout YOU BEAUTY!