Transmission mechanisms from the slowing in China

Today’s commentary

My thesis has been that China was the main driver of volatility in emerging markets and that tapering by the Federal Reserve was merely a proximate trigger. I still believe this to be the case. However, increasingly I am becoming concerned about the growth trajectory in the US, and the federal deficit is a big part of why. Transmission mechanisms for instability due to this slowing are considerable, and underestimated. Some thoughts below

I had intended to write this post on the US due to the deficit information that was released yesterday, but the events in China are forcing me to broaden the scope. The slowing in China in terms of credit is why. I will explain below. But let’s start with the US.

As I wrote on Tuesday, the narrative forming as we begin to 2014 is this: “After 5 hard years of anemic growth and lacklustre job prospects, the US economy broke out in the second half of 2013 toward a recovery sustainable without Fed stimulus. Job growth is almost at a 200,000 jobs per month pace. Consumer sentiment and business confidence are rising. Bank credit conditions are loosening. Consumer credit is rising. As a result, GDP is growing at above 3%. With defaults at a cyclical low and businesses flush with cash, soon capital investment and wages will rise too, making 2014 even better than 2013. As a result, for the first time since the recovery began, the Fed did not ramp up its asset purchase programs. Rather it dialled them back, letting interest rates rise and the yield curve steepen, both signs of an improved economic outlook.”

And while I initially believed this narrative to be largely consistent with what was actually happening, my doubts have grown considerably. I see the recent non-farm payrolls data as a statistical aberration, perhaps due to seasonal factors. Continued low jobless claims make me less concerned here. However, where I am concerned is regarding consumer demand. On the one hand, you have an increase in consumer credit, particularly in student and auto loans. And this is bolstered by the rebound in house prices. On the other hand, however, house price gains are slowing, the auto sector is piling on inventory, wage growth is non-existent and the federal deficit shows government as a net drag that will not compensate. The picture, I am therefore seeing is one of moderating growth that we should expect to surprise to the downside instead of surprising to the upside as I had believed last month.

More on the US and a big review of Chinese slowing transmission mechanisms after the jump

I talked a bit about the inventory problem on Tuesday. Inventory building is not a concern if the end demand materializes. But to the degree it does not, then the inventories will have to worked off, slowing production and output. This is how garden-variety recessions happen, by the way. The dance between expectations, production, hiring and consumer spending gets far enough out of whack that the downshift in production to rebalance output with end demand leads to such a feedback loop with jobs and retail sales that the economy ends up in recession. We are not there yet because I believe we are beyond stall speed. But the risk here is that inventories will be worked off, leading to a slowing of growth – something which a slowing of capital investment would exacerbate.

Where I am more concerned now is this tidbit from Reuters:

“The federal government ran $10.4 billion into the red last month, the Treasury Department said on Wednesday in a monthly statement. Analysts polled by Reuters expected a budget deficit of $27.5 billion.”

Now, traditionally, you learn in economics that reducing the fiscal deficit is a good thing because deficits are bad. But this is not accurate. Deficits are generally an ex-post accounting result that flows from previous budgetary decisions and the real-time progression of tax receipts. This means that with deficits we are seeing how previous fiscal decisions are interacting with the private sector, giving us a sense of whether demand from the public sector is a drag on or an addition to growth.

When you see the budget deficit falling, you have four questions to ask:

1. Are previous fiscal policy decisions geared toward reducing or increasing government spending?
2. Are previous fiscal policy decisions geared toward reducing or increasing private demand via the tax lever?
3. How is private demand progressing independent of fiscal policy?
4. What are the expected tax receipts from that private sector output?

What I am seeing is a fiscal policy geared toward reducing government spending that is neutral on taxes against a backdrop of middling end demand that is increasing tax receipts. The fact that the deficit is receding more quickly than expected in the present scenario could either be because end demand is higher than expected or because the fiscal drag from contractionary fiscal policy is greater than expected. My sense is that we are seeing a combination of both but largely due to inventory builds. And that’s where I have to draw conclusions. 

My logic in terms of conclusions here goes as follows: The federal government is actively seeking to reduce deficits and local and state governments are still constrained by previous hardship. Fiscal policy will be a drag on private growth. In the private sector, GDP is growing above 3% merely because of builds in inventories. End demand is really only increasing at a 2% rate, and this because of an increase in consumer credit. That means we are above stall speed, merely because of inventory builds and an increase in credit. Without those two contributions, GDP would be growing at 1-2%. With that backdrop, a decline in deficits that is unexpectedly large suggests a greater fiscal drag than anticipated. If either an inventory purge begins or consumer credit pulls back, we are back at stall speed.  

At the same time, the Fed is tapering asset purchases because it is looking the other way. I don’t think the asset purchase taper signal will reverse course until and unless GDP growth weakens into the stall speed 1-2%. That’s bond bullish and equity bearish. What we would need to see to counteract this is a credit accelerator or wage growth, with wage growth being the only factor which would sustain the business cycle for more than a few quarters.

Then there’s China. It is tightening up on credit conditions and this has killed the commodities bull market. Look at Australia, with the highest unemployment rate in 11 years. That speaks to the power of China. And we see this everywhere in commodity exporter countries. But these are only the real economy effects. I am more concerned about the financial system transmission mechanisms because sudden stops are due to panics in the financial world due to a propagation of tightening in one locus of weakness to other areas. It’s not just the real economy effects. More important is the feedback loop from real economy to the financial system and the propagation of that feedback across different sectors, asset classes and economies. For example, the reason we had a financial crisis in 2007 was because subprime was not contained. The contagion into other markets intensified to the point that we had a panic and a sudden stop.

I found Ambrose Evans-Pritchards piece today insightful on the transmission of Chinese tightening.

 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.

These are big numbers – bigger than during the last financial crisis. As my friend Yves Smith remarked via email to me: “$1.1 trillion in foreign currency loans v. about $500 billion of unmatched dollar exposures in Eurobanks during the crisis.”

Then there is the problem of Chinese lending abroad. 

China is a big factor in this new dynamic. Today, the world is focusing on the implications of slower growth in China. But it also needs to start focusing on the role of Chinese banks as a source of liquidity for neighbours and emerging markets generally.

China liquidity crunch

Any capital crunch in China is not immediately obvious. So far, much of the concern over China has to do with excessive credit growth, which is now close to 180 per cent of GDP. A new study from the Institute of International Finance shows that Chinese international bank loans amounted to almost $100bn last year, a jump of more than 60 per cent since 2011, (the figure excludes Hong Kong, Macau and Taiwan).

Since the study relies on data on publicly announced loans, that number probably understates the extent of activity. Moreover, Chinese banks lend to corporate borrowers that otherwise might have trouble attracting capital, such as in Pakistan or Bangladesh.

But excess credit growth may soon be yesterday’s problem. As the Chinese regulators put pressure on the shadow banks by implementing periodic liquidity squeezes, they will chill all banking activity and make the price of all money more expensive, since the line between the regulated and unregulated world is so porous.

This is a second transmission mechanism.  

A third comes via hot money flows within emerging markets. To the degree that EM is the locus of today’s credit crisis due to exposure to China, the flow of money across borders is the concern. And the volatility due to ETF investments should be a source of concern.

ETFs now dominate flows in and out of emerging markets, and the money held in them is plainly flightier than money held in other instruments. According to Strategic Insight Simfund, since the beginning of 2009 there have been six separate quarters in which emerging market ETFs have suffered net outflows. There have been no such quarters for actively managed funds in the sector, while the far smaller flows into open-ended funds have also been steady.

While it is true that ETF investors are responding to macroeconomic and corporate fundamental factors when they make buying and selling decisions, the money they hold is plainly impatient.

The bottom line here is that China is slowing due to a crackdown on excess credit growth, with bad credit rising to a cyclical high. The impact will be a rise in the cost of funding which will impact the financial sector via Chinese lending in foreign currency and Chinese bank lending abroad. To the degree that these factors are severe enough, the increase in hot money flows into and out of emerging markets represents a risk that could trigger even greater contagion in another round of EM volatility. I believe we will see more rounds of emerging markets volatility and that this will create contagion. The questions are how much slowing will Chinese authorities allow, how much contagion will we see as a result, and what kinds of macro policies and international policy co-ordination will we see. A slowing in the US will only cause contagion into developed markets to be that much more severe. The potential for a new global crisis is definitely there.