9 September 2015

The coming tidal wave of Chinese money-printing


As the World gets bigger it seems to become more volatile. So, its financial markets ride an endemic 8/9-year roller-coaster with dizzying, white-knuckle peaks occurring in 1972, 1981, 1989, 1998, 2007/08 and now maybe again in 2015. Once more disappearing money flows are the culprits behind crashing stock markets. Are we no longer slaves to defunct economists as Keynes prophesised, but unattractively chained instead to a World money cycle? The chart below highlights the latest dip in the levels of Global Liquidity, according to the GLITM indexes regularly tracked by CrossBorder Capital since the mid-1980s. Businesses cannot operate without cash and summing the amounts that are available to borrow and invest across World financial markets makes up Global Liquidity.

Figure 1- The Global Liquidity Cycle (Index 0-100)


Source: CrossBorder Capital

The gyrations of Global Liquidity explain market movements around 6-12 months ahead and predict economies over the following year. Their importance represents a harsh wake-up call for the modern economy. The US$100 trillion pool of Global Liquidity pumps up economies and supports an upside-down pyramid of vastly greater financial wealth held in bonds, stocks and real estate. America and China dominate, with each responsible for around one-quarter of total flows. China’s liquidity pool has grown 12-fold in a little over a decade, spurred by export surpluses and a domestic credit boom that have fuelled an eye-popping over-expansion in China’s domestic asset economy.

With her money taps forcibly shut-off some 18-months ago by policy-makers, China now faces the ugly prospect of dealing with Japanese-like zombie banks and too much Soviet-like heavy industry. Not surprisingly, China’s GDP is skidding downwards to a much slower growth path with negative pressures on financial markets and the exchange rate and crushing blows already hammering World commodity prices lower.

The recent devaluation of the Chinese RMB is a watershed event, understandably drawing dark comparisons with the 1930s currency war. This race-to-the-bottom saw disturbingly large swings in exchange rates and a sequence of thudding devaluations as first Britain, then Japan, America and finally stubborn France succumbed, the latter dropping her parity and losing a government. Could China be the new France? There are parallels, but we think a closer comparison is mid-nineteenth century finance, when the City of London was in its prime and where, largely absent Central Bank control, fragile wholesale money markets and private discount houses dominated the supply of liquidity.

The 2007/08 Financial Crisis and the associated failures of the investment banks, Bear Stearns and Lehman Brothers, echo the 1866 collapse of London-based Overend-Gurney, then the World’s largest private financial institution. Many things have changed in global finance in the last two-decades to re-cast markets in this Victorian light.

First, high street banks have been eclipsed as lenders by the capital markets and industrial corporations have turned from being net short-term borrowers into net short-term lenders, effectively reversing the polarity of the financial system and underscoring a greater need for timely Central Bank support. More loans now take the form of securitized credits, often funded by exotic off-shore instruments, ‘approved’ by suspect credit-rating agencies and back-stopped in extremis by more of the same.

Second, global factors, such as fast-moving cross-border capital flows, are increasingly important, and China, with its large but still untested financial structure, has muscled forward to become a major borrower and lender. China’s People’s Bank (PBoC) is now the World’s biggest Central Bank: one fifth larger than the mighty US Federal Reserve.

Third, monetary shocks arising from financial innovations and worryingly large policy errors by Central Banks are more frequent events. Cross-border capital flows intensify these problems by pushing up currencies and asset markets, worsening trade deficits and pulling in ever more capital in an arc of boom/ bust, until reality strikes and the money suddenly stops.

This is the problem as we see it right now: Global Liquidity is again flagging and 2008-like funding cracks are re-appearing. Despite the much-trumpeted easings by the European Central Bank (ECB) and Bank of Japan, other key Central Banks are either tightening funds, notably the US Fed or seriously ‘behind the curve’, such as the People’s Bank of China. China must do more, but the more it is forced to ‘print money’ the greater the risk that the RMB devalues further and so spreads China’s deflation into the World economy.

2015 is China’s Lehman Brothers’ moment. She feasted too freely from the fountain of cheap, global credit. Back in 2008, seriously low levels of funding liquidity at the heart of American finance triggered a credit crisis across US wholesale money markets, which at the time provided nearly half of all US credit. China’s own wholesale markets have grown to make up one-third of the economy’s total credit and are already facing near-identical funding problems, as key players struggle to hang on to precious US dollar borrowings in the face of rising finance costs and capital flight.

This was the hidden message behind August’s devaluation of the RMB currency. China needs to pull-in foreign exchange. She has devalued once and will do so again. Given China’s whopping excess industrial  capacity, it may even require a 20% plunge in the RMB to keep her factories running: such devaluation looks politically impossible – not least with a fast-approaching US Election year – but let’s not rule out another 5-10% slide. This may help keep down high street prices on Oxford Street and Fifth Avenue, but it will heap pressure on to China’s Asian economic neighbours and may even compromise Britain’s nascent trade recovery.

Behind this coming RMB weakness will be attempts by China’s People’ Bank to print money. Here think America’s 2008/09 policy response and the huge monetary injections labelled QE1, which later extended into QE2 and QE3. The Federal Reserve’s balance sheet ultimately jumped by over 4 times; the Bank of England’s by six times and the Swiss National Bank’s by a whopping nine times.

With the World’s private sector still mired by sky-high levels of debt breeching 100% of GDP, larger than ‘normal’ volumes of liquidity are needed to keep economies on-track. Looking ahead, our numbers show that the World desperately needs more liquidity and China may be the instigator of several new rounds of quantitative easing. In deference, call these CE1, CE2 and CE3. More cash is coming…it must.

Michael J. Howell is Managing Director of CrossBorder Capital, a London-based financial research company that advises key investors Worldwide. Prior to founding CrossBorder in 1996, Michael was Research Head at Barings and Research Director at Salomon Brothers. He can be contacted via liquidity.com.