Ben Bernanke's recent press conference and China's interbank market crash may appear to have little in common but the truth is rather different. For both the U.S. and China are trying to deflate asset bubbles caused by excessive money printing and interest rates being kept too low for too long. And politics is largely behind the timing of their decisions to clamp down on these bubbles. Bernanke is desperate to avoid the mistakes of his disgraced predecessor, Alan Greenspan, whose loose money policies blew up soon after he departed the post. And China's President Xi Jinping would rather have an economic slowdown now than later on so that he can blame it on his predecessor, Hu Jintao.
The question for investors is whether Bernanke or Xi will blink, choosing to reflate their asset bubbles (the U.S. bubbles are principally in stock and bond markets while China's are more broad-based) rather than face the consequences of unwinding them. At Asia Confidential, we're not certain of anything. But our best guess is that the U.S. economy is too fragile and deflationary forces are too strong for QE tapering to take place this year. China is a different matter as we now suspect the new president may just have the political backing and will to carry out tightening measures. Either way though, the asset bubbles in both countries are likely to deflate, it's just a matter of how and when this happens.
The context to market gyrations
What's behind the wild market gyrations of the past week? It's clear that the U.S. and China are attempting to deflate their asset bubbles and markets don't like it. To better understand why this is the case though, it's important to appreciate how these bubbles developed in the first place.
And to do that, we need to step back in time. All the way back to 1994, in fact. Why this year, you ask? Well, it's then that China devalued its currency by 50%. Asia Confidential believes that this singular event has been the key driver behind events leading up to the financial crisis and thereafter.
That's because the 1994 devaluation resulted in a substantial under-valuation of the yuan. This under-valuation created the conditions by which China was able to become an exporting powerhouse.
For China to become this powerhouse though, it needed buyers. The developed world was only too happy to oblige, scooping up the cheap Chinese products. It didn't matter that consumers in the developed world didn't have enough money to purchase all of these products. They simply piled on debt to pay for them.
The beauty of this arrangement was that China received U.S. dollars from U.S. consumers. Its subsequent trade surplus led to the rapid accumulation of foreign exchange reserves, which China used to buy U.S. government bonds. This in turn kept U.S. bond yields and interest rates low, making it cheap for U.S. consumers to take on more debt to buy Chinese products and other things (such as local property).
But to maintain its currency peg to the U.S. dollar, China had to create yuan through the printing press. This whole process helped created inflation at home and deflation abroad.
An elegant arrangement, no? Not so much. Since 2008, this seemingly virtuous circle has slowly unravelled as the developed world pays down its excessive debt load. Meantime, political pressure to appreciate the yuan has resulted in that currency recently reaching 19-year highs versus the dollar.
You're probably wondering what all of this has to do with the events of the past week. Well, the developed world has never paid back those excessive debts as governments thought that process would be too painful for their countries to take. Instead, those governments took over the private sector debts and printed loads of money to try to inflate these debts away.
That printed money has been used to buy U.S. government debt, which has depressed U.S. bond yields and interest rates. That's hurt savers, who've searched for better returns in risk assets, such as stock markets.
There's little doubt that the U.S. Federal Reserve's solutions to the 2008 crisis have provided artificial support to stock and bond markets. And undoubtedly to the U.S. housing market too. Bernanke is clearly worried about all this and it goes some way towards explaining his push to reduce U.S. stimulus.
Meanwhile, China's response to the 2008 crisis was to print 4 trillion yuan (close to US$600 million in 2009 terms) to pump prime its economy and prevent a downturn similar to the one which occurred in the developed world.
This pump priming went largely into fixed asset investments, financed principally via debt at the local government level. It's directly resulted in a property bubble of substantial proportions. It's also led to debt issues, with total credit to GDP in China increasing from 125% to 200% over the past five years.
China's new president came to power in March and inherited this mess. He's intent on deflating the credit bubble without crashing the economy. That intent is behind the spike in China's interbank interest rates in recent weeks.
Bernanke is focused on his legacy
Why is Bernanke choosing to act now to reduce stimulus then? Before getting to that, let's take a quick look at what he actually said at his press conference post the FOMC meeting. Bernanke suggested that QE cutbacks could begin later this year if growth picks up as the Fed projects, unemployment comes down and inflation comes closer to the central bank's 2% target. If those expectations bear out, the Fed could stop QE altogether by the middle of next year, when it forecasts unemployment to drop to 7%.
In short, Bernanke thinks the economy is improving to the point that it will be able to stand on its own without the assistance of stimulus. And this line has been parroted by the vast majority of the investment community.
But there appears to be more than a few holes in this argument:
If that's the case, why would Bernanke be pushing ahead with this tapering? We suspect that politics may have something to do with it. In a recent TV interview, President Obama all but said that Bernanke won't serve a third term as Fed Chairman from January next year.
This means that Bernanke, like any good politician (central bankers are as much politicians as they are economists), has one eye on his current job and the other eye on how he'll be remembered in the history books. He won't want to become another Alan Greenspan, who left office shortly before the 2008 financial crisis that he arguably contributed too.
Put bluntly, QE tapering - even a small reduction thereof - offers the chance for Bernanke to be remembered as the responsible central banker rather than the one who re-created asset bubbles that led to a further financial crisis.
Xi Jinping's iron fist
China has been the other focus of market attention, with good reason. The country's interbank market - where banks lend money to each other - essentially froze for a short period of time. And the central government initially refused to step in to provide the liquidity to get the market functioning again. It only caved in when things became critical.
Below is the Shanghai Interbank Offered Rate (SHIBOR) courtesy of Zero Hedge
Sure, there were a number of factors which contributed to the spike in interbank rates, including:
There was a lot of silly commentary out of the U.S. about how this was China's "Lehman" moment - alluding to 2008, when Lehman Brothers went under, freezing U.S. credit markets. It ignored the fact that the central government largely initiated the interbank rate spike.
The obvious question is: why would the central government do this? And the logical explanation is that it wants banks to slow the pace of lending and this was its crude way of communicating the message. We think, though, that almost everyone has missed a key driver for the credit crackdown.
The government and its new leaders are no dummies. They realise that they inherited a mammoth credit bubble that's in the process of bursting. They have two choices:
In other words, Xi knows that China's credit bubble will burst. It's better to get it out of the way to preserve his authority. He can then get on with the job of introducing the crucial reforms needed to restructure the economy and drive growth over the next decade.
What happens from here?
You're probably thinking that this is all well and good, but what can we expect to happen from here? The truth is that no one knows. But here are a few tentative guesses:
The question for investors is whether Bernanke or Xi will blink, choosing to reflate their asset bubbles (the U.S. bubbles are principally in stock and bond markets while China's are more broad-based) rather than face the consequences of unwinding them. At Asia Confidential, we're not certain of anything. But our best guess is that the U.S. economy is too fragile and deflationary forces are too strong for QE tapering to take place this year. China is a different matter as we now suspect the new president may just have the political backing and will to carry out tightening measures. Either way though, the asset bubbles in both countries are likely to deflate, it's just a matter of how and when this happens.
The context to market gyrations
What's behind the wild market gyrations of the past week? It's clear that the U.S. and China are attempting to deflate their asset bubbles and markets don't like it. To better understand why this is the case though, it's important to appreciate how these bubbles developed in the first place.
And to do that, we need to step back in time. All the way back to 1994, in fact. Why this year, you ask? Well, it's then that China devalued its currency by 50%. Asia Confidential believes that this singular event has been the key driver behind events leading up to the financial crisis and thereafter.
That's because the 1994 devaluation resulted in a substantial under-valuation of the yuan. This under-valuation created the conditions by which China was able to become an exporting powerhouse.
For China to become this powerhouse though, it needed buyers. The developed world was only too happy to oblige, scooping up the cheap Chinese products. It didn't matter that consumers in the developed world didn't have enough money to purchase all of these products. They simply piled on debt to pay for them.
The beauty of this arrangement was that China received U.S. dollars from U.S. consumers. Its subsequent trade surplus led to the rapid accumulation of foreign exchange reserves, which China used to buy U.S. government bonds. This in turn kept U.S. bond yields and interest rates low, making it cheap for U.S. consumers to take on more debt to buy Chinese products and other things (such as local property).
But to maintain its currency peg to the U.S. dollar, China had to create yuan through the printing press. This whole process helped created inflation at home and deflation abroad.
An elegant arrangement, no? Not so much. Since 2008, this seemingly virtuous circle has slowly unravelled as the developed world pays down its excessive debt load. Meantime, political pressure to appreciate the yuan has resulted in that currency recently reaching 19-year highs versus the dollar.
You're probably wondering what all of this has to do with the events of the past week. Well, the developed world has never paid back those excessive debts as governments thought that process would be too painful for their countries to take. Instead, those governments took over the private sector debts and printed loads of money to try to inflate these debts away.
That printed money has been used to buy U.S. government debt, which has depressed U.S. bond yields and interest rates. That's hurt savers, who've searched for better returns in risk assets, such as stock markets.
There's little doubt that the U.S. Federal Reserve's solutions to the 2008 crisis have provided artificial support to stock and bond markets. And undoubtedly to the U.S. housing market too. Bernanke is clearly worried about all this and it goes some way towards explaining his push to reduce U.S. stimulus.
Meanwhile, China's response to the 2008 crisis was to print 4 trillion yuan (close to US$600 million in 2009 terms) to pump prime its economy and prevent a downturn similar to the one which occurred in the developed world.
This pump priming went largely into fixed asset investments, financed principally via debt at the local government level. It's directly resulted in a property bubble of substantial proportions. It's also led to debt issues, with total credit to GDP in China increasing from 125% to 200% over the past five years.
China's new president came to power in March and inherited this mess. He's intent on deflating the credit bubble without crashing the economy. That intent is behind the spike in China's interbank interest rates in recent weeks.
Bernanke is focused on his legacy
Why is Bernanke choosing to act now to reduce stimulus then? Before getting to that, let's take a quick look at what he actually said at his press conference post the FOMC meeting. Bernanke suggested that QE cutbacks could begin later this year if growth picks up as the Fed projects, unemployment comes down and inflation comes closer to the central bank's 2% target. If those expectations bear out, the Fed could stop QE altogether by the middle of next year, when it forecasts unemployment to drop to 7%.
In short, Bernanke thinks the economy is improving to the point that it will be able to stand on its own without the assistance of stimulus. And this line has been parroted by the vast majority of the investment community.
But there appears to be more than a few holes in this argument:
- U.S. economic growth is mediocre at best, particularly when considering that it's coming out of such a deep downturn.
- The majority of recent data points on the economy has disappointed, indicating a slowing growth rate in the short term.
- If economic growth remains at current levels, or falls, Bernanke's unemployment targets won't be reached.
- The biggest issue of all is one that I have alluded to many occasions and only recently have other commentators started to pick up on: U.S. inflation is slowing and deflation remains the primary risk right now.
If that's the case, why would Bernanke be pushing ahead with this tapering? We suspect that politics may have something to do with it. In a recent TV interview, President Obama all but said that Bernanke won't serve a third term as Fed Chairman from January next year.
This means that Bernanke, like any good politician (central bankers are as much politicians as they are economists), has one eye on his current job and the other eye on how he'll be remembered in the history books. He won't want to become another Alan Greenspan, who left office shortly before the 2008 financial crisis that he arguably contributed too.
Put bluntly, QE tapering - even a small reduction thereof - offers the chance for Bernanke to be remembered as the responsible central banker rather than the one who re-created asset bubbles that led to a further financial crisis.
Xi Jinping's iron fist
China has been the other focus of market attention, with good reason. The country's interbank market - where banks lend money to each other - essentially froze for a short period of time. And the central government initially refused to step in to provide the liquidity to get the market functioning again. It only caved in when things became critical.
Below is the Shanghai Interbank Offered Rate (SHIBOR) courtesy of Zero Hedge
Sure, there were a number of factors which contributed to the spike in interbank rates, including:
- The gradual tightening in policy this year.
- A sharp fall in foreign exchange inflows in May due to a government crackdown on illicit activity.
- Banks hoarding cash for seasonal reasons.
There was a lot of silly commentary out of the U.S. about how this was China's "Lehman" moment - alluding to 2008, when Lehman Brothers went under, freezing U.S. credit markets. It ignored the fact that the central government largely initiated the interbank rate spike.
The obvious question is: why would the central government do this? And the logical explanation is that it wants banks to slow the pace of lending and this was its crude way of communicating the message. We think, though, that almost everyone has missed a key driver for the credit crackdown.
The government and its new leaders are no dummies. They realise that they inherited a mammoth credit bubble that's in the process of bursting. They have two choices:
- Reflate the credit bubble and risk enormous economic damage down the track.
- Or acknowledge that the economy will slow as the bubble pops and attempt to manage it as best they can.
In other words, Xi knows that China's credit bubble will burst. It's better to get it out of the way to preserve his authority. He can then get on with the job of introducing the crucial reforms needed to restructure the economy and drive growth over the next decade.
What happens from here?
You're probably thinking that this is all well and good, but what can we expect to happen from here? The truth is that no one knows. But here are a few tentative guesses:
- In the short run, the U.S. economy is unlikely to recover, weighed down by excessive debt. And deflation will remain the primary risk.
- China's economy may well have some encouraging weeks or months. For instance, upcoming data should be somewhat better given the accelerated banking lending in early June, rollout of significant infrastructure projects across several key cities and a normalisation in consumption following the Avian flu scare. However, the general economic trend will be down and it could well take a long time to recover.
- It's our expectation that Xi will positively surprise when he announces broad-ranging economic reforms, likely in the second half of this year. Substantive moves toward privatising state assets may be a centrepiece. It won't be hard for Xi to exceed the very low market expectations on this. Any reforms will do little to mitigate the current economic slowdown though.
- In the long-term, all the asset bubbles in the developed world and China will deflate in one way or another. All bubbles pop eventually and these ones will be no different. No central banker or leader can prevent this from happening. They can try, but they'll only succeed in delaying the process.