World asleep as China tightens deflationary vice

We keep our fingers crossed as we glimpse the first foam of a deflationary Ch'ient'ang'kian coming our way from China. The world's central banks have no margin for error

By Ambrose Evans-Pritchard

8:00PM GMT 12 Feb 2014

.Societe Generale has defined its hard landing as a fall in Chinese growth to a trough of 2pc, with two quarters of contraction. This would cause a 30pc slide in Chinese equities, a 50pc crash in copper prices, and a drop in Brent crude to $75.  Photo: MARK RALSTON/AFP/Getty Images

China's Xi Jinping has cast the die. After weighing up the unappetising choice before him for a year, he has picked the lesser of two poisons.

The balance of evidence is that most powerful Chinese leader since Mao Zedong aims to prick China's $24 trillion credit bubble early in his 10-year term, rather than putting off the day of reckoning for yet another cycle.

This may be well-advised for China, but the rest of the world seems remarkably nonchalant over the implications. Brazil, Russia, South Africa, and the commodity bloc are already in the cross-hairs.

"China is getting serious about deleveraging," says Patrick Legland and Wei Yao from Societe Generale. "It is difficult to gently deflate a bubble. There is a very real possibility that this slow deflation may get out of control and lead to a hard landing."

Zhang Yichen from CITIC Capital said the denouement will be a ratchet effect since China has capital controls and banks are an arm of the state, but that does not make it benign. "They are trying to deleverage without blowing the whole thing up. The US couldn't contain Lehman contagion, but in China all contracts can be renegotiated, so it is very hard to have a domino effect. We'll see a slow deflating of the bubble ," he said.

What is clear is that we are dealing with a credit expansion of unprecedented scale, equal in size to the US and Japanese banking systems combined. The outcome may matter more for the world than anything that the US Federal Reserve does over coming months under Janet Yellen, well signalled in any case.

Societe Generale has defined its hard landing as a fall in Chinese growth to a trough of 2pc, with two quarters of contraction. This would cause a 30pc slide in Chinese equities, a 50pc crash in copper prices, and a drop in Brent crude to $75. "Investors are still underestimating the risk. Chinese credit and, to a lesser extent, equity markets would be very vulnerable," said the bank.

Such an outcome -- not their base case -- would send a deflationary impulse through the global system. This would come on top of the delayed fall-out from China's $5 trillion investment in plant and fixed capital last year, matching the US and Europe together, and far too much for the world economy to absorb.

The effects of this on large parts of Latin America, Africa, the Middle East, and core Eurasia would hit before offsetting benefits accrued to consumers in the West. Such commodity shocks are "asymmetric" at first. Southern Europe would fall over the edge into deflation, pushing Italy, Portugal, and Spain deeper into a debt compound trap.

China did of course blink in January when the authorities stepped in to cover the $500m liabilities of the trust fund, “Credit Equals Gold No. 1”. It is the fifth trust rescue in opaque circumstances in recent weeks. Yet it would be hasty to conclude that President Xi is backing away from his Third Plenum vows to end to the bad old ways.

The central bank (PBOC) is tightening methodically, allowing the benchmark 7-day repo rate to ratchet up by 200 basis points to 5.21pc over the last year. It drained a further $50bn from the system this week.

Its latest quarterly report has turned hawkish, even though producer prices are in steep deflation, and the M2 money supply is slowing. It complains that “reliance on debt is still rising” and thathidden risks in the financial sphere require attention”.

Zhiwei Zhang from Nomura says China has entered a "prolonged period of policy tightening" that will push up bank lending rates by as much as 90bp this quarter, leading to a chain of defaults.

The tell-tale signs are obvious in the central bank's handling of reverse repos and maturing bills. The yield on corporate AA 1-year bonds has jumped 272 basis points to 7.15pc since June. "We think the PBOC intends to raise the whole spectrum of interest rates to push deleveraging," he said.

This will be a rough ride. JP Morgan's Haibin Zhu says the shadow banking system alone has jumped from $2.4 to $7.7 trillion since 2010, and is now 84pc of GDP. To put this in perspective, the total US subprime debacle was $1.2 trillion.

Haibin Zhu says there is mounting risk of "systemic spillover". Two thirds of the $2 trillion of wealth products must be rolled over every three months. A third of trust funds mature this year. "The liquidity stress could evolve into a full-blown credit crisis," he said.

Officials from the International Monetary Fund say privately that total credit in China has grown by almost 100pc of GDP to 230pc, once you include exotic instruments and off-shore dollar lending. The comparable jump in Japan over the five years before the Nikkei bubble burst was less than 50pc of GDP.

Source: People's Bank of China, CEIC, BIS

The transmission channel to the global banking system is through Hong Kong and Macao. Bejing's credit squeeze is causing a scramble for off-shore dollar credit to plug the gap. It is this that keeps global regulators awake at night, for foreign currency loans to Chinese companies have jumped from $270bn to an estimated $1.1 trillion since 2009.

The Bank for International Settlements says dollar loans have been growing "very rapidly and may give rise to substantial financial stability risks", enough to send tremors across the world.

The BIS data shows that British-based banks -- a broad-term, including branches of US and Mid-East outfits -- are up to their necks in this. They hold a quarter of all cross-border bank exposure to China. By contrast, German, Dutch, French and other European banks have cut their share from 32pc to 14pc as they retrench to shore up capital ratios at home.

Foreign claims on China by bank nationality
CH: Switzerland, DE: Germany, FR: France, GB: Great Britain, JP: Japan, NL: Netherlands, oEU: Other Europe, RoW: rest of world, US: United States. Source: BIS

This may be why the Bank of England's Mark Carney warned before Christmas that the "parallel banking sector in the big developing countries" now poses the greatest risk to global finance. Officials at the Bank recently showed him an unsettling report by the Hong Kong Monetary Authority on China's off-shore loan risks.

Charlene Chu, Fitch's China veteran and now at Autonomous in Beijing, told The Telegraph last week that these dollar debts were large enough to set off a fresh global crisis if mishandled.

Whether this unfolds depends entirely on how the world responds. One can hardly be sanguine. Raghuram Rajan, India's rock star central bank chief, says global co-ordination has "broken down". Turkey, Brazil, and South Africa, among others, are tightening into economic downturns to defend their currencies. Others are distracted by their own political struggles at home.

The Fed's Janet Yellen can hardly back away from bond tapering as her first order of business, even though US data has turned soggy. She has to shake off her (unmerited) reputation as a dove. Besides, most Fed governors are on the warpath against asset bubbles.

They may be right, but bear in mind that the growth rate of America's M2 money supply has halved over the last year. It might have contracted since April without $85bn of bond purchases by the Fed each month.

The European Central Bank is paralysed after the German constitutional court read the riot act last Friday, strongly suggesting that its bond rescue plan (OMT) is Ultra Vires and a violation of "monetary financing".

The ECB cannot easily carry out quantitative easing to cushion a deflationary shock in the teeth of such a judgment, even if QE is a different tool. In German politics they are the same.

The decision came disguised as a referral to the European Court, but was in reality a warning shot, as former judge Udo di Fabio has more or less said. The German court cannot stop the ECB buying bonds but it can stop the Bundesbank from taking part, and must do so if actions are Ultra Vires. That is enough.

So we keep our fingers crossed as we glimpse the first foam of a deflationary Ch'ient'ang'kian coming our way from China. The world's central banks have no margin for error

February 16, 2014 5:28 pm

America risks becoming a Downton Abbey economy

Inequality must be addressed, with free markets playing a pivotal role

Inequality has emerged as a major issue in the US and beyond. A generation ago it could reasonably have been asserted that the overall growth rate of the economy was the main influence on the growth in middle-class incomes and progress in reducing poverty. This is no longer a plausible claim.

The share of income going to the top 1 per cent of earners has increased sharply. A rising share of output is going to profits. Real wages are stagnant. Family incomes have not risen as fast as productivity. The cumulative effect of all these developments is that the US may well be on the way to becoming a Downton Abbey economy. It is very likely that these issues will be with us long after the cyclical conditions have normalised and budget deficits have at last been addressed.

President Barack Obama is right to be concerned. Those who condemn him for “tearing down the wealthy” and engaging in un-American populism are, to put it politely, lacking in historical perspective. Presidents from Franklin Roosevelt to Harry Truman railed against the excesses of a privileged few in finance and business

Some have gone beyond rhetoric. Confronted with rising steel prices, John Kennedy sent the FBI storming into corporate offices and is widely thought to have ordered the authorities to audit executives’ personal tax returns. 

Richard Nixon used the same weapon in 1973, announcing tax investigations “of the books of companies which raised their prices more than 1.5 per cent above the January ceiling”. All were reacting in their own way to a phenomenon that Bill Clinton has described best: “Although America’s rich got richer ... the country did not ... the stock market tripled but wages went down.”

Given the widespread frustration with stagnant incomes, and an increasing body of evidence suggesting that the worst-off have few opportunities to improve their lot, demands for action are hardly unreasonable. The challenge is knowing what to do.

If income could be redistributed without damping economic growth, there would be a compelling case for reducing incomes at the top and transferring the proceeds to those in the middle and at the bottom. Unfortunately this is not the case. It is easy to think of policies that would have reduced the earning power of Bill Gates or Mark Zuckerberg by making it more difficult to start and profit from a business. But it is much harder to see how such policies would raise the incomes of the rest of the population. Such policies would surely hurt them as consumers by depriving them of the fruits of technological progress.

It is certainly true that there has been a dramatic increase in the number of highly paid people in finance over the last generation. Recent studies reveal that most of the increase has resulted from an increase in the value of assets under management. (The percentage of assets that financiers take in fees has remained roughly constant.) Perhaps some policy could be found that would reduce these fees but the beneficiaries would be the owners of financial assets – a group that consists mainly of very wealthy people.

It is not enough to identify policies that reduce inequality. To be effective they must also raise the incomes of the middle class and the poor. Tax reform has a major role to play. The current tax code is so badly designed that it is very likely to be having the effect of reducing economic growth. It also allows the rich to shield a far greater proportion of their income from taxation than the poor. For example, last year’s increase in the stock market represented an increase in wealth of about $6tn, of which the lion’s share went to the very wealthy.

It is unlikely that the government will collect as much as 10 per cent of this figure. That is because of a host of policies that favour the rich, such as the capital gains exemption, the ability to defer tax on unrealised capital gains, and the fact that gains on assets passed on at death are not taxed at all. Similarly, the corporate tax system allows value to flow through it like a sieve. The ratio of corporate tax collections to the market value of US corporations is near a record low. The estate tax can be more or less avoided with sophisticated planning.

Closing loopholes that only the wealthy can enjoy would enable taxes to be cut elsewhere. Measures such as the earned income tax credit can raise the incomes of the poor and middle class by more than they cost the Treasury, because they give people incentives to work and save.

It is ironic that those who profess the most enthusiasm for market forces are least enthusiastic about curbing tax benefits for the wealthy. Sooner or later inequality will have to be addressed. Much better that it be done by letting free markets operate and then working to improve the result. Policies that aim instead to thwart market forces rarely work, and usually fall victim to the law of unintended consequences.

The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary

Copyright The Financial Times Limited 2014

Heard on the Street

Central Banks Walk Policy Tightrope

Efforts to Safeguard Economies Risk Causing New Distortions

By Richard Barley

Feb. 17, 2014 7:16 a.m. ET

It's a fine line to walk. Central banks in many developed economies are holding rates near zero to protect fragile economies. But they are also rightly wary about the potential for those low rates to stoke new distortions, such as housing bubbles.

The apparent answer to this challenge is so-called macroprudential policy, seen as a targeted way to intervene to rein in imbalances such as excessive lending via regulatory measures. The Bank of England has made clear that this, rather than the blunt tool of a rate increase, is the preferred option in dealing with excesses in a revitalized housing market; the Swiss National Bank is already trying out tweaking capital requirements to manage the risks in its real-estate market.

But will it work? The BOE points to examples such as changes to risk weightings for commercial real estate in India in 2005-2006, or to car loans in Brazil in 2010, where there was a large reduction in lending. That suggests that very targeted measures can work.

But while macroprudential policy might slow lending growth, it may not have the same clout as an interest-rate hike in changing borrowers' behavior.

In Sweden, the Financial Supervisory Authority noted in December that despite higher capital requirements for banks, lending has continued to grow, while the impact on lending rates had been small; Swedish household debt stands at above 170% of disposable income. The Riksbank says knowledge about the effectiveness of macroprudential policy is still limited.

In Switzerland, the SNB has had to launch a second round of increases to the capital required to be held against mortgages. So far, the effect of macroprudential policy there appears limited. UBS's Swiss Real Estate Bubble Index continued to climb into the "risk" category in the fourth quarter; house prices are growing faster than income and mortgage debt is now around 110% of gross domestic product. Swiss fixed-interest mortgage rates have risen only 0.08-0.09 percentage point, notes Nomura. Talks are now under way on further measures that may include tightening lending criteria.

The risk is that consumers may only respond to something that puts clear limits on what they can borrow, such as caps on loan-to-value ratios, or debt-service ratios. These would undoubtedly be powerful, but could also be controversial. The BOE has said it thinks there needs to be a broad public debate about LTV restrictions for them to be acceptable.

The key issue here may well be one of signaling. An announcement that a central bank is requiring banks to raise their countercyclical capital buffers, or that it is changing sectoral capital requirements, is clearly going to be more difficult to explain than a rise in a country's interest rate. And it will take a lot to drown out the signal that rates at historical lows send to housing markets and home buyers. The tightrope central banks are trying to walk may be a perilous one.

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