Many markets have now recovered from the initial wave of selling associated with the Chinese mini-devaluation catalyst. This should be expected. Some of these markets will surely continue higher. Nevertheless, the Chinese devaluation still represents an important marker in terms of global economic vulnerability. And so I want to map out a mental model on how a crisis is transmitted and why I believe this is a crisis.
First, let me point out two twitter encounters I had yesterday that precipitated this post. The first one involves the U.S. and its GDP numbers. Yesterday, I was in transit to New Orleans. The U.S. GDP report came out and I went to the airport lounge and banged out my post on the limited impact of China’s devaluation crisis on the U.S.. I have been saying that the macro data in the U.S. are too good and the U.S. trade flows too small for a mini-devaluation to have an undue impact on the economy. 3.7% is a one-off figure with the pace of recovery still in the ~2%ish range. Nevertheless, my baseline is for U.S. growth to continue, only fading as the oil price decline takes its toll via bankruptcies in the U.S. shale market.
After the U.S. data were released, a usually reliable source told me about the GDP data being skewed by inventory builds, whose contribution to GDP were the highest outside of wartime. I tweeted this information, only to learn via a snarky but correct intervention from Ian Shepherdson that the tweet was incorrect – miles off, in fact. Since I was on a plane by this time, I had limited research capacity. But I did ascertain fairly quickly that the tweet was wrong. So I deleted it. My source told me subsequently that the numbers were based on Gross Domestic Income, an income and profits measure for the National Income and Product Accounts, that was very weak in Q2. But, since inventories are a product measure, we are talking apples to oranges.
The moral of the story of course is to not tweet any data until you do your own analysis. However, for me, the incident highlighted the fact that, while some are looking for recession around every corner, the U.S. economy remains on track and is not particularly vulnerable to exogenous shocks. In fact, just as I wrote this sentence the BEA released its personal income and outlays email, informing me that personal income was up 0.4% in July and disposable personal income was up 0.5%. To me, these are figures that support continued growth despite weakening capital expenditure numbers. The China mini-devaluation is a catalyst with fewer transmission mechanisms into the U.S., which is not vulnerable at this time.
The second twitter encounter involved Brazil. The Wall Street Journal had a fairly reductionist article about Brazil’s problems being caused by over-reliance on commodities that it linked to on its China Real Time blog. So I tweeted the link without comment. Mark Dow intervened to argue that the post was rubbish because Brazil has a large continental economy with exports being only a small portion of it. The real problem in Brazil was an unsustainable credit boom. My reply was that I understood what was being implied i.e. that the commodities slowdown matters more now than ever. And moreover, credit boom ends are not about causation; they are almost always about catalysts, contagion and vulnerability. But I take Mark’s point. Here’s a link to the exchange on twitter.
The last exchange is why I am writing this post – and it dovetails nicely with the first. The storyline here is that credit crises are not about causation. They are primarily about catalyst events being transmitted in some capacity to other vulnerable sectors of the domestic or global economy and causing enough contagion to bring down a vulnerable credit structure.
For example, in the Asian Crisis in 1997, people talk about the Thai Baht devaluation as precipitating the whole chain of events. And I think that’s directionally correct. The Thai Baht devaluation caused markets to re-assess the health of Thai corporate debtors. There was a bubble in Thailand and the devaluation popped this bubble once and for all. And once the problems in Thailand were re-assessed, markets turned elsewhere in Asia and found similar imbalances: high foreign currency debt loads, balance of payments problems, and crony capitalism. The result then was an emerging markets crisis that eventually hit Brazil, Argentina and Russia as well, then leading to the LTCM crisis and bailout. But note the vulnerability is what made the crisis palpable and widespread.
Similarly, when we look at the U.S. subprime crisis that started with Household International’s subprime writedown in February 2007, we have to remember that subprime was a small market relative to the size of the US economy, even then. But it was also integrally connected to the entire U.S. housing market, where serious bubbles were evident. And once the subprime market imploded it rippled outward into the rest of the housing market, popping the U.S. housing bubble and spreading contagion everywhere. The contagion via financial intermediaries and the vulnerabilities due to overextended credit structures is what made the subprime crisis global.
A final example is Dubai World in November 2009. I described it as an exogenous shock with a sort of butterfly contagion effect. And that is because it was a catalyst for re-assessment about sovereign debt structures – and ultimately a number of sovereigns proved vulnerable due to excessive debt in a currency they don’t control, precipitating the European sovereign debt crisis.
This is how crises work. The model is catalyst, contagion and vulnerability. You need all three for the crisis to occur and then the question goes to how potent the transmission mechanisms are and how vulnerable the credit structures and economies affected are. Take Brazil and China, for example. It is clear that Brazil had a massive private credit binge and that this came unstuck, making its economy vulnerable to an exogenous shock. So when we see commodity and oil prices collapsing and trade flows collapsing, this is a catalyst hitting a vulnerable economy. If you look at the Wall Street Journal story though what stands out for me is this:
But China is the X-factor. Brazil’s exports to China tumbled by 19% in the first seven months of this year.
For more than a decade, China has been there when Brazil needed it most. Brazil entered the latest commodity upswing, around 2002, verging on default, but Brazil’s economy began to catch fire from resource prices buoyed by Chinese demand.
Brazil then again looked as if it could come undone after the global financial crisis in 2008. China’s $586 billion stimulus package helped reignite global demand for what Brazil produces.
A 19% reduction in trade with Brazils largest trading partner for both imports and exports as credit growth comes unstuck is a huge exogenous shock, even for a continental-sized economy like Brazil’s. Imagine if the U.S. had a 19% reduction in trade with the EU while credit growth was declining and the federal government was engaged in fiscal tightening for example. Thats the equivalent of what is happening in Brazil right now. And this goes to catalyst, contagion, and vulnerability. They are all huge for Brazil.
So as I look at what is going on in China, I am asking myself: how much of a catalyst is what’s happening? Where is the likely contagion transmission path, if any, and how large is it? And finally, how vulnerable is the economy, credit structure being affected by contagion?
With China, a mini-devaluation is meaningless in terms of trade flows as a conduit for contagion. More meaningful are the loss of a marginal buyer in over-supplied commodity markets and the pressure on the Chinese domestic economy to further that loss. Right now, the Chinese economy is slowing as it transitions to a consumer-led economic model. And the non-performing loans associated with the old economic model will make this transition fraught. For the Chinese to manage the transition well, they will need to accept the slowing, which they have done. But more than that, they will need to put policies in place to enable the transition. And that means letting the currency act as a release valve.
I believe the Chinese will resist depreciation. They will support the currency through intervention as we see them doing today, with a large revaluation supported by demand from state-owned banks acting on behalf of the central bank. But I believe the slowing will be too great for the Chinese to continue this policy. And they will be forced to allow the currency to depreciate sometime this year or next. A 10% total depreciation from the pre-mini devaluation level is only a few percent below today’s level. And while that won’t give the Chinese economy a boost via exports, it will give domestic financial conditions breathing room. But it will also have a negative impact on commodities and EM countries.
For now, we are in a holding pattern, and I expect EM and commodity markets to stabilize. But once the depreciation continues, sentiment will shift and the next phase of the Chinese currency crisis will begin.
P.S. – Europe’s economy is doing better than expected in my view. I continue to see upside there, particularly in Ireland and Spain. Again, in terms of catalysts, contagion, and vulnerability, there is not enough for Europe to be drawn into this meaningfully at this time.