Thursday, December 8, 2016

The next crisis?

Where will the next crisis come from?  Every crisis starts with a pile of debt that can't be paid back, and shady accounting to hide that debt. When one big one goes under, everybody starts to question the shady deals they've invested in, the extend-and-pretend game ends, heretofore simple rolling over of short term debt suddenly ends, and the run starts. Governments bail out. Really big crises happen when governments run out of bailout power or will and you have a sovereign debt crisis or inflation. Governments bail out by borrowing, but if people won't lend the government money to bail out, either default or inflation must follow.  Reinhart and Rogoff describe a frequent "quiet period" between financial crisis and sovereign crisis. So far we have just had quiet.

So, where around the world is there a lot of debt that might not be paid back and really shady accounting? Well, duh, China, right?

So if I have to dream up a nightmare scenario it goes something like this: A pile of debt in China is found wanting. China's government takes desperate steps -- huge bailouts, sell its pile of treasuries, force people to buy worthless assets, print up lots of money, but prop up its value by stopping people from taking currency abroad, and so forth.

The next step is some sort of "contagion" to the rest of the world. Foreign businesses turn out to have invested more in China than we think (shady accounting again). Or supply chains are disrupted, we discover we're pretty darn dependent on trade and so on.

Meanwhile, the usual "information-insensitive" securities become "information-sensitive" in Gary Gorton's nice language. Italian banks are ready to go, and a hint Italy might leave the euro to bail them out might enough to get the Italy run going. Seeing China blow up might be just the hint people need to think about that. That event would be enough to put Italian and European  sovereigns at risk, or force the ECB to real monetization in the trillions.

Can it spread to the US? We're usually the quality to which people fly. But Illinois and California's pensions don't look a lot better than Chinese banks really. Student loans loom. The Federal government has guaranteed a lot of debts! And the long-run cash flow forecasts for the US government aren't great. The prospects of a strong economy help demand for our debt, but a China-Europe crisis could well send us back to a recession. And in a global sovereign crisis, China and Europe will be cashing in their treasuries.  Can we really borrow another $5 trillion  for bailout and stimulus while foreigners are dumping $4-5 trillion or so of our treasuries?

This is absolutely not a forecast. The definition of a crisis is that it is unpredictable. It needs a lot of things to go wrong, a lot of firebreaks to fail. (Equity is one essential firebreak against asset failure turning in to liability failures.) After the event, it becomes obvious, and we hail a few lucky guessers (ignoring those guessers' may other wrong calls).

At best it is a scenario, a chain of events that could happen, with very small probability.   The next crisis -- there will be one, someday, until that charmed day that the world adopts equity-financed banking and governments run fiscal surpluses -- may come from somewhere else totally.  But the art of risk management is to think through improbable chains of events.

Why bring it up now? Well, in today's Wall Street Journal Lingling Wei reports that "China's banks are hiding more than $2 Trillion in loans," In the lead editorial rightly making fun of currency manipulation, the WSJ notes that China has already dumped $1 Trillion dollars of its reserves (likely US Treasuries) and facing $100 billion per quarter capital outflows. China is imposing strong limits on its citizens ability to move capital out of the country (translation: sell Chinese currency, bonds, bank accounts and get same in dollars abroad). At the start of the new year, individual Chinese will be allowed to take out their yearly allotment. I would guess they do it soon.

All these are signs of propping a currency up, not pushing it down; declining demand for currency and bonds that will be needed if China wants to do a massive bailout of bad debts. (Allow bankruptcies? Well, we in "capitalist" America don't do it, so I doubt China will do it either.)

These are signs that a run on China is already starting. Not all runs explode. Many fizzle out. But maybe this first link in the chain is closer to blowing up than we think. How are those firebreaks doing?


  1. How long can the head in sand charade go on? I've been expecting the ECB to explode for over a year. The question is what will be the actual "trigger?" If we pretend long enough, is the false reality real?

  2. Bet on Chinese citizens being more nimble than Chinese bureaucrats. OTOH, the run on China is entering its third year. It would assume that the hottest money is already out the door.

  3. The (thoughtful) blog states, "China has already dumped $1T of its reserves and facing $100B per quarter capital outflows. (How that squares with a trade surplus I don't know. Do any commenters?)"

    I missed the WSJ article, so I might have misunderstood the paragraph, but I'll give it a go anyway...

    Net Exports = Net Capital Outflows in an open economy model. So, the statement makes sense: positive capital outflows = trade surpluses. If by "capital outflow" you mean billions of RMB flowing from China to the rest of the world. The increased supply of RMB abroad depreciates the RMB against other currencies ... making Chinese exports cheaper and generating the trade surplus. If China is imposing limits on RMB capital outflows, one could interpret that as an effort to prevent further depreciation of the RMB. But, since a higher-valued RMB depresses demand for Chinese exports, it's debatable how much that actually benefits China. (Rich F.)

  4. How does a fall in foreign reserves squares with a trade surplus? Very easy: a private capital outflow (this is the accounting identity of the balance of payments)

  5. Thanks to Antonio and Anonymous. An obvious brain fade on my part, I removed the comment.

  6. I'm deeply worried about my country's hidden credit risks and potential financial crisis. However, there is little things I could do as an individual except that taking out yearly allotment of 50,000 US dollar. Recently, we are not allowed to buy insurance products or pay insurance premium in Hong Kong (HK dollar linked to US dollar) via China UnionPay Card, a previous alternative way to allocate asset overseas as well as circumvent foreign currency quota.

  7. Doc at the Radar StationDecember 9, 2016 at 6:37 AM

    Perhaps this is analogous to a lake 'turning over':
    The countries running persistent CA surplus/deficits flip and we will have an appreciating RMB and a depreciating dollar. The Chinese capital flight finishes flying and real estate prices in developed economies simmer down, etc. The length and depth of the persistence will determine the intensity of the crisis. Looks like a potential whopper.

  8. Peoples china has folded under zero of the last twenty debt crisis freak out warnings

    Maybe it's just a different system then Wall Street over sees
    At least so far

  9. Not sure if my analysis is correct, but it seems unclear that China selling Treasuries to finance bail-outs would cause severe problems in US Treasury markets. If they are selling Treasuries to purchase Renminbi then by definition they must be allowing at least some entities to sell RMB denominated assets to purchase Treasuries, right? In the event that Chinese financial institutions are facing runs, doesn't it seem likely that many entities with RMB denominated accounts would be happy exchange these assets for US Treasuries without demanding huge discounts?

    1. True, for every buyer there is always a seller, but at what price?

  10. MMMmMMMM???? Chinese debts, USA debts, Pension debts, Italian debts but no mention of Japanese debts. MMMMMMM???? Interesting.
    Did I miss a paragraph?

    1. No, I just ran out of steam with all the piles of debt around the world ready to ignite.

    2. With US debt at $19T and Mr. Trump ready to borrow massive(?) amounts of new debt, I fear for our, and especially the next generation, ability to try and dig out of this mess.

    3. I share your concern: How about a different scenario? It may be so simple, hence overlooked.

      Let's say that Trump's borrowing will include funds for infrastructure improvement. Basic Classical economics tells us that there are 2 primary elements of production: #1 Land (the Appraisal Institute includes natural resources in the definition of land). #2 human labor. Let's assume one infrastructure project includes building a bridge for 1 billion dollars, and that it will take 2 years (100 weeks) to build this bridge. That's 1% of a billion (10 million dollars) per week of wealth produced. As we know, labor works first, THEN gets paid; let's assume payday every week. We also know, especially on such a project, that suppliers will deliver bridge making materials first, THEN LATER get paid. So if we produce $10,000,000 of wealth each week, the government could print currency to pay for the labor and land (resources) circumventing the FED, debt and inflation free. The currency, instead of being borrowed into the system would be 'bought' into the system, again debt and inflation free. Let's have the government print the money based on wealth and not debt.

      This may assuage your concern.

    4. Sounds like "Social Credit" doctrine - ever heard of it?

  11. Still, China and the People's Bank of China are below their 3.5% inflation target, and the domestic economy is growing at 6-7% annually.

    It appears the PBoC engages in quantitative easing or helicopter drops by simply buying bad loans with printed money.

    This leaves the bank system in good condition, but threatens higher rates of inflation and currency depreciation. Of course a cheaper yuan would help China exports, so I wonder why they worry about that.

    As for higher rates of inflation, the China economy used to grow even faster with higher rates.

    China also has the luxury of "owing money to themselves."

    My guess is the China monetary-banking system is actually quite sturdy, if not optimized for efficiency.

    Is there some wry humor in Western economists talking a China banking collapse for 20 years…while our system in fact collapsed?

    Perhaps we should head to China to learn, not lecture….

    PS I prefer free enterprise systems. But since we have a central bank and they have a central banks, on that level our systems are close. Their system seems better.

    1. Except we have ten million untrustworthy and they have a hundred million untrustworthy!

  12. It is interesting to see the role of investments in this case, especially with investments being a highly volatile category of spending. Like any investor, the sight of your investment outlet defaulting would be an extremely unsettling sight, especially with China not providing arbitrage or collateral. Wont China's selling of debt hurt its economy more than it would help? As the selling of bonds would increase interest rates, decrease bond prices, cause demand for bonds to decline, and ultimately slow their economy? In this case would it not make more sense for China to buy bonds (increase bond prices, drive down interest rates, increase monetary supply, and stimulate the economy) from private Chinese investors in order to reverse the situation?


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