A System-Wide Margin Call

The greatest risk to financial markets everywhere...

GLOBAL MARKETS were briefly cheered earlier this week by news that the Chinese government was planning to relieve its banks of up to $450 billion in poorer quality local authority loans, hence removing a looming threat to the nation’s credit-fuelled expansion, writes Sean Corrigan of Diapason Commodities at the Cobden Centre.

As is usual with China, though, this was both something and nothing. Nothing because the announcement was only one of vague intent rather than a concrete proposal, much less one with a verifiable timetable. As is so often the case, the authorities may well be employing the typical ruse of benefiting from an initial headline effect and the subsequent goldfish memory capability of the vast majority of investors who only want to believe the best about the place, in any case.

It was nothing too, because the ‘bail-out’ will probably take the time-honoured form of simply re-labelling one form of irredeemable debt as a more prestigious marque – this time, perhaps, one with an MOF imprimatur on it – without altering the fact that it will remain as a low-interest drag on bank balance sheets in perpetuity.

Never mind, the banks can always shore up their balance sheets by selling another slice of overpriced equity to the biddable gweilo suckers who are so anxious to get a piece of the China-to-the-Moon action, even if they then cough up most of the proceeds by issuing a series of dividends to their governmental majority shareholders, with which these latter will meet the re-packaged junk interest payments.

If this seems a classic shell game of the kind so well described in Walter & Howie’s ‘Red Capitalism’, there were also rather more disconcerting echoes of Frank Dikotter’s ‘Mao’s Great Famine’ in an official news story which attributed the calamity, that the recent drought in China has given way to a series of deadly floods, to the failure of the local cadres to arrange for the peasants to ‘volunteer’ to complete water management projects in the agricultural low season as they used to do in the 60s and 70s.

Given that the during the first of these alone – the risibly named Great Leap Forward – a near-unimaginable 45 million of those same peasants are reckoned to have been starved or beaten to death, the wistfulness with which this was recalled sheds a worrying light on the unsoftened callus which still passes for the heart of the central planner. These are the men in whom the fate of your business resides, still as mindless in their career-boosting pursuit of central directives to boost ‘growth’ – if, thankfully, nowhere near as brutal – as their fathers were in the attempt.

At root, of course, the Great Chinese Bank Lending Splurge was a fiscal programme, not a commercial one: one which was inherently monetized and hence one which has led straight to the inflationary problems of today.

Worse even than that, this New Deal was just as morally corrupting and societally enervating as have been all its less-than illustrious predecessors. In a one-party state, there may have been no need to ’Tax, tax, tax. Spend, spend, spend. Elect, elect, elect,’ as Harry Hopkins categorized FDR’s cynical exploitation of executive patronage in 1930s America, but the money will nonetheless have gone preferentially to the well-connected – the party loyalists, the SOE apparatchiks, and the princeling-run oligopolies – each eager to extend their fiefdoms as much as possible along the way.

Now that credit is being partly rationed, these too are the ones who will suffer last and least, meaning that genuine entrepreneurs are the ones who will have to bear the brunt of an adjustment process which has not only tightened funding and raised interest rates – especially the usurious curb rates which are often their only source of working capital and which some sources say are running at 5% a month – but which has crushed their export margins under the weight of the Yuan’s ascent and sharply raised the cost of both the labour and material inputs they require to stay in business.

Even the state mouthpiece, the Shanghai Times, admitted as much in running the results of a survey conducted by the All-China Federation of Industry and Commerce which said that SMEs across the 16 provinces canvassed were suffering a ‘cash crunch’ as tight as that experienced at the height of the Lehmans-AIG Crisis in 2008.

With the Western press full of stories of Chinese ‘fraud caps’ and with the signal, first ever failure of a domestic IPO this week to top a run of disappointing after-markets for a whole host of flotations, undeniable evidence of the deterioration in the economic environment may coincide with widespread investor distrust to provide a rather salutary end to this latest outbreak of Sinomania.

Certainly, equities are beginning to look vulnerable, while the latest trade data shows that exports have been essentially static in Yuan terms for the past six months, with the YOY rate trending down even more sharply than in the run-up to the bust.

Apart from another round of anaemic import-export numbers (e.g., for copper, where we are already back to the stationary, 2001-08 mean), one portentous indicator is the volume of coal exports from Australia – and the corresponding length of the queue off the principal port of Newcastle – given that almost four-fifths of these are bound for either India or the China-Taiwan-Japan-Korea global production hub.

Another country getting little bang for its monetized buck is dear old Blighty – the UK – where well over 90% of gilt issuance has been taken up by the banks, stepping in for the rather more embarrassing direct money printing of the Old Lady herself, conducted in 2009.

The author is old enough to remember how controversial was the proposal, mooted and then adopted during the previous housing crash, to insist no longer that, as an act of anti-inflationary prophylaxis, only government debt sold to non-monetary institutions and individuals would count as being ‘funded’ (admittedly, this was fast becoming a dead-letter with the rapid development of repo markets). We are a long way from such days of virtue, alas!

Here, again, we have a direct impediment to the necessary cleansing and re-ordering of society in that the feckless and unfortunate are preferentially receiving finance at the expense of the would-be phoenixes who might foster prosperity for all.

Is it any wonder that the country still runs a trade deficit of roughly £100 billion a year (a per capita equivalent of over $800 bln were the US to be as badly placed), despite the 20% decline in its currency (a real effective exchange rate decline which was the biggest undergone of the 57 nations the BIS tracks with the sole exception of benighted Iceland!)?

Is it any wonder that prices are rising so fast (despite the supposedly prohibitive Keynesian presence of an ‘output gap’) when so much of the money being created is not giving rise to goods and services, but is being used to furnish the means for the unproductive to maintain their soft budget lifestyle in all its £650 billion total, £120 billion deficit majesty?

But if Britain looks no further forward in clearing up the toxic legacy of RobespiBlaire and Culpability Brown (or Crash Gordon, if you prefer), who else will take up the challenge? The Europeans? What, with the little political will which remains after failing to break the Greek impasse being squandered on the mindless rush to ’decarbonise’ and to denuclearise the most successful economies on the Continent simultaneously?

It’s not even that there is much of a Plan B to replace the reactors, other than that of despoiling the environment, ruining the vistas, decimating the wildlife, and crippling both industrial and household budgets with vast, rent-sucking arrays of unwieldy, uneconomical and largely impractical windmills and solar panels.

In Germany, some commentators are already muttering darkly of an emerging ‘eco-tyranny’ and referring sourly to the unhealthy consensus which has sprung up among the main political parties as a GED – or a Gruenes Einheitspartei Deutschlands.

As the Swiss environment minister, Doris Leuthard, so marvellously put it, when hailing the Bundesrat’s decision to abandon the clean, quiet, low ’footprint’ source of 38% of the country’s electricity without having any obvious replacement to hand in a small, land-locked country where even shale gas exploration has met with overwhelming regulatory difficulties: ‘ I believe in a Switzerland of innovation.’

Talk about the politics of the Tooth Fairy!

Even as it stands, there are just a few hints that some of the shine may be coming off the Mittelstand’s gold stars. Export revenues – while still running at double digit rates – are seeing a progressively faster deceleration, with domestic sales picking up smartly in what may be a sign of the inflationary pressures bubbling up in this notoriously lacklustre sector.

Be aware, too, of the greatly elevated German business reliance on north Asia, whence it sends twice as many exports as in 2005, with their relative scale increasing by half, from 22% of EZ exports then, to 35% today. If China sneezes… Gesundheit!

Looking further afield, Japan is not yet in any position to help and – besides – it, too, is now too intimately tied up with what happens on the Asian mainland to provide a separate driver, its tragedy being that it has replaced its traditional over-dependence on one intemperate giant (the US) with a fate closely intertwined with the caprices of two.

As for the US, there is not too much new to say on the monthly data flow, with what there is of note being more long-term in nature. Here, the quarterly financial numbers show the maintenance of the split between the vitality of Corporate (or should that be Corporatist?) America and that of the rest of the private sector, as well as the contrast between the unretarded profligacy of the state and the ongoing resizing of the ’shadow’ banking sector.

What we can also see is the scale of the distortions being introduced into the market where, despite the superficial health of both profits and cash flow (these a touch less impressive if we adjust for either of the US Dollar’s internal or external losses of value), it is apparent that the balance sheet is still being strip-mined to salt the income statement and, more particularly, the per share ratios via debt-financed equity buybacks.

Even as this increases the overall fragility of the corporate structure, however, the Fed’s egregious obliteration of capital market pricing signals has kept equities looking ‘cheap’ – with dividend yields anomalously above an artificially-depressed interbank lending interest rate and equity earnings yields at par with QE-shrunken corporate bond yields for the first time in almost three decades.

This cannot end well.

The opening paragraphs of this report should leave few doubts of our view of China in the long run. Even if the final bill for this vainglorious attempt to frustrate economic law may be long in coming (after all, the Soviets managed 70 years even though they were far worse at this than the present regime in Beijing), we still strongly suspect that an interim down payment – in the form of a nasty cyclical recession – cannot long be postponed.

This leaves the fate of the whole commodities complex hanging in the balance, as a moment’s consideration of the energy market should make plain.

In the latest edition of its seminal annual Statistical Review, BP’s calculations suggest that, over the past five years. China alone has been responsible for no less than one-sixth of the increase in natural gas use, four fifths of the incremental oil use, nine-tenths of added coal use, and five-eighths of the rise in overall world energy uptake.

Can you imagine what will happen to the whole pricing structure – and to all that entrepreneurial activity predicated on extrapolations of current growth rates – if that prodigious rate of surconsumption one day takes a breather?

For now, some of the implicit bearishness has been temporarily dispelled by OPEC’s failure to agree upon a hoped-for schedule of production increases. This is not at all a sound basis for clinging on in the game, however, since this may simply remove any residual commitment to existing quotas among those anxious either to secure America’s favour or – to put the mutual dilemma another way – to remind the Hegemon that it might prove a little inconvenient if its mealy-mouthed support for the Arab Spring protests and its selective denunciation of the Syrian oppression (combined with a notable silence regarding events in Bahrain) were to be extended to the core desert sheikdoms.

Quite who holds the best hand in this game of geopolitical poker is not clear, but what is fairly apparent is that the interests of neither party will be served by an undue restriction of the flow of oil, or too sharp a rise in price form present levels.

As we have discussed in recent editions, industrial metals can hardly remain immune to a major deceleration, much less an outright reversal in the hothoused recovery, but all the signals are that the slowdown in real money supply – evident almost everywhere but in the US – is indeed making itself felt in reduced economic activity in accordance with the usual timetable.

As such that only leaves the speculative financial element in play to maintain high prices, but here, too, the sands of time are fast running out.

Having become increasingly aware of the true import of QEII for asset prices – and increasingly concentrated in the positions taken in response – the market is now attempting to persuade itself that the current economic weakness is somehow a positive in that it will allow for some form of QEIII to be introduced almost without delay and so will see the no interruption to the inflation of what has become a spreading foam of constituent bubbles in many, many of the various markets for risk.

Our opinion of the Bernanke Fed is not exactly of the highest, but it seems to have escaped our wishful thinkers that even Blackhawk Ben is neither quite that stupid nor that powerful.

Yes, any protracted weakness will doubtless be greeted with a premature renewal of stimulus, but the weight of argument needs first to shift away from the present irritation with Washington’s naked transfer of resources to the Lords of Misrule from the pockets of the hard-pressed middle classes, and that will take both time, lower oil and food prices, and sharply falling stock markets to accomplish.

QEIII may or may not be a certainty to follow QEII in the attempt to lead us back to the broad, but treacherous, uplands of pre-Crisis activity, but the way will not be opened before we have first spent some time traversing the vale of tears.

Politics, too, plays a role here, for the incumbent’s interest is to get the pain out of the way now – to sit by while gas prices drop and the grocery bill becomes a little less onerous – before putting the pedal to the metal sometime next spring so that another burst of false optimism can course through the economy over the succeeding summer and early Fall. Thus will those poor old goldfish again become befuddled enough to vote the great man back into the White House in November.

Ironically, though the timing is more clandestine, it seems as though a similar imperative may be at work in China, too, where President Hu Jintao is thought to be preparing to hand over power to Xi Jinping sometime next year.

If inflation represents the greatest threat to both social stability and the prestige with which the current leader can hope to embellish his record, then the calculus may be that inflation can be fought a little more forcefully over the coming months, even at the cost of the jobs of the politically nugatory non-state workers. Then – and perhaps only then – can victory be declared and the next great Chinese bubble inaugurated.

All too many markets have become indiscriminately entangled in this recent updraught and as the air hisses out of the Bernanke balloon under which they have been borne aloft, it may also be that they maintain their fatal embrace for much of the way back down as gravity reasserts its mastery.

As trendlines break across a whole host of asset classes and bellwether instruments, it may be that we are about to face one of those system-wide margin calls that the past three-and-a-half years of prevarication, procrastination, and pusillanimity have done nothing to make any the less likely to happen.

As with all things in markets, none of this is set in stone, but it decidedly is the greatest hazard we currently face and it would therefore be wise for everyone to ensure that they have adjusted their business or investment exposures accordingly.

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