January 27, 2014
Do you remember the Undertones My perfect cousin’ about a perfect, mollycoddled cousin who was the apple of his mother’s eye and got on the nerves of all the other less-than-perfect cousins?
Every family has one, although I suspect the Irish weakness for mothers’ filial devotion probably makes the Irish perfect cousin considerably more unbearable. The mothers just can’t help bragging, protecting and becoming excessively agitated at the slightest sign of a cold, a cough or a splutter from the golden one’.
The perfect cousin is the delicate child’ who, at least in the mother’s eyes is always in danger, always susceptible and needs to be always looked after. Any slight threat, such as falling in the playground, mingling with the wrong’ crowd or not taking his daily vitamins, spells disaster for the delicate child and sends the protective mother into apoplexy.
The outsized reaction of financial markets to news of problems in China on Thursday and Friday, reminded me of the delicate child and its mother.
After five years of the ultimate protective mother, the Federal Reserve, injecting cheap money at every juncture, the markets are like the delicate child. Their reaction is hardly the wolf of Wall Street; more like the wuss of Wall Street.
After years when economic reality was wrapped in the soothing balm of quantitative easing, any small threat to the global recovery script prompts wild over-reactions by the wusses of Wall Street. These out of proportion, short-term reactions – such as a massive sell-off on a worse-than-expected number, or a buying surge on the back of a better-than-expected number – are characterising financial markets these days.
This week we had a brilliant example. At the end of the week, the delicate markets sold off dramatically, particularly emerging markets. In fact, now that I think of it, maybe the most telling warning sign should have been when the great and good in Davos were unanimous in saying everything is all right and the world is a safe place again. On queue, the markets sold off. The reason was China, which may come as a surprise to you when you have been told that China was the future.
The fear, highlighted in this column a few times in the past, is that the massive credit easing in China of the past few years has led to a huge bubble in the Chinese banking system. We know from our experience in Ireland that massive credit growth rarely leads to a sustainable period of economic growth – as suggested in textbooks – but, in contrast, leads almost inevitably to bubbles, defaults and bankruptcies.
Defaults never come in ones
In the past few days, evidence of these bankruptcies has emerged in China. At the moment the figures are minuscule in the context of the second-largest economy in the world, but there is one thing we know about defaults: like cockroaches in New York, they never come in ones. When you see one, you know you have thousands.
Deep inside the Chinese banking system are small financing companies, financing millions of sure thing’ investments to millions of people hoping to make a quick buck.
These are the Chinese equivalent of the development land’ financing which emerged in Ireland in the 2000s. Do you remember them? They were the ones sold by all sorts of charlatans who contended that if you bought a field outside Edenderry it would be worth hundreds of millions in time. These scams are a function of the banks having too much money and nothing to spend the money on, so they finance rubbish.
In China the assets’ financed weren’t open fields, but open mines. The mining company comes to the banks and says it wants to borrow money, much like the developer in Ireland in 2005. Instead of lending the company the cash, the banks turn the loan into an investment’ and gather together its high net worth individuals. These people are told to buy a product’ which is nothing more than a loan to a mine (which may or may not work) dressed up as a financial investment’.
This is what the Irish banks and brokers were doing all the time in the development land scam here a few years back. In China this has been going on all the time, but on an unfathomable scale.
Then suddenly one of the mining companies goes bust because there is nothing under the ground. Suddenly people begin to ask questions. How many of these loans are out there? And if there are loans, are the banks safe?
Overnight from having been the growth story of the century, China becomes the place in the world most likely to have an Asian Lehmans. This vista scares the bejaysus out of the financial markets because they start thinking that there is something much bigger and nastier hidden in the entrails of the Chinese banking system.
The delicate child screams for its Mammy (the safety of the stable countries), apologising for hanging out with the wrong crowd (the emerging markets) and wanting to go home (into stable investments).
In a panic on Thursday, the financial markets sold everything risky’ and flew back to the safety of Mammy’s skirt, which in the financial world is the US treasury market. On Friday the sell-off kept going.
All across the world, from Argentina to Turkey, South Africa to Brazil, the currencies of the countries fell sharply on Friday.
When you take a bit of altitude, none of this seems to make sense. Why does a wobble in China affect the value of the South African rand?
The answer to this legitimate question is leverage. The global financial markets are gelled together by huge borrowings. In the past year, many trillions of Japanese yen were borrowed to buy stuff around the world, for example, South African rand. The rand offers high interest rates to investors at 5 per cent; yen rates are practically zero. So the traders borrow in yen and buy rand.
But when the panic sets in, they sell the rand because they want to own dollars and not be exposed to the risks in places like South Africa. So the rand falls, for no real reason other than people are worried about China and this fear prompts them all to buy dollars and yen and Swiss francs.
This is what happened all over the world on Friday. Investors sold everything and scuttled home to safety. The wolves of Wall Street at the faintest hint of trouble turned into the wusses afraid of their own trades â€“ the ones they were probably bragging about a few days ago.
But what about the threat of a Chinese Lehmans, is it real? Who knows. Is there a risk that all those dodgy loans will go bad?
Yes! Can’t the central bank with the most foreign reserves in world handle this? Maybe
Perfect cousins, like the Undertones’ Kevin, who had a degree in economics, maths, physics and bionics’ will tell you that Chinese fundamentals’ are sound.
David McWilliams writes daily on global finance and economics at globalmacro360.com