Re: Geopolitics/Inflation/USD-Ball In A China Shop.
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Re: Geopolitics/Inflation/USD-Ball In A China Shop.
Today I divert your attention from the provincial woes of wayward Silicon Valley lenders to the REAL ticking time bomb of the global financial system -- China.
While the past week in the financial markets has revolved around the demise of Silicon Valley Bank and the ramifications therein, I personally don’t think the extremely poor risk management practices of a bank focused on banking the most speculative sector of the economy will lead to a major domestic banking crisis. Consequently, I do not believe it derails the Fed’s primary mission to fight domestic Inflation, which brings me back to the consequences of a Strong USD.
Some of you may have read the paper I co-wrote and presented at West Point last month. Ironically, we got knee-jerk flak for “advocating more Weaponization of the USD” (mainly from people who didn’t actually read the paper) when we’re actually arguing for the exact opposite. When people talk about “Weaponization of the USD,” they’re primarily talking about financial sanctions / seizures of Russian USD-based reserves. We are not advocating these tools in our competition with China.
Our paper advocates less reactive policies that overly “Weaponize the USD” through financial sanctions (which drive the search for alternatives) and more proactive policies that:
Defend our flank by properly aligning Industrial Policies with geostrategic initiatives and not creating self-inflicted fragilities (like our current Energy Policies).
Harness the relative economic strength of the US by adopting a Strong USD Policy which accomplishes the twin objectives of fighting domestic Inflation as well as economically challenging China in particular.
Here’s a TLDR way to analogize our thesis:
Why is China particularly vulnerable to a Strong USD?
China's flagging growth has been front-and-center in my mind, but their avenues for stimulus are quite limited. As a huge fan of Greek mythology, I took the liberty of using this graphic of Odysseus trying to negotiate the strait between Scylla and Charybdis to illustrate the precarious quandary currently facing China and the PBOC:
This meme merely scratches the surface of China’s current macroeconomic challenges. Our West Point Paper highlights several other structural icebergs that have also been building up to this point:
China, despite its reputation as the primary challenger to the US-led RBO, may be in the worst shape of all. Aside from disadvantaged Geography and challenged access to Natural Resources, China’s demographic problem is arguably the worst in the world, projected to lose nearly half of its population by 2100.
The failure of Evergrande in 2021 and the ensuing fallout in its real estate sector coupled with its quixotic zero-Covid policies have curtailed its economic growth prospects without government stimulus, and government stimulus at a time that the Fed and other central banks are simultaneously tightening policy to curb inflation invites CNY depreciation. Lack of convertibility in CNY masks the potential capital flight from the country if it allowed its currency to float freely. According to Credit Suisse, “if China were to fully liberalize its capital account, 20- 25% of household savings would be geographically diversified away from China.”
The People’s Bank of China (PBOC) is also conspicuously absent from many central bank comparisons, likely due to the opacity/unreliability of data from China and due to the obfuscatory interrelationship between the PBOC and state banks; that said, many analysts point to China’s debt- fueled boom of the last several decades as unsustainable, as demonstrated in Figure 12:
Figure 12: Total Private Credit
I want to delve specifically into the “obfuscatory interrelationship between the PBOC and state banks” and why the chart above seems directly at odds with the chart below, taken from a recent paper entitled “China’s Balance Sheet Challenge” by Nicholas Borst:
This is a chart that is heavily exploited by the Anti-USD crowd and used often to show why China is poised to overtake American hegemony.
Too bad it is a facade.
China’s true leverage is hidden behind a complex web of overleveraged borrowers ranging from State-Owned Enterprises (SOEs), private Real Estate Developers, and Local Government Financing Vehicles (LGFVs). As Borst puts it, “As strong as the central government’s balance sheet is, it is not strong enough to bail out every contingent liability in China.” The extent of these financing arrangements make Enron’s off-balance sheet shenanigans seem like child’s play. To borrow a graphic from a recent Zerohedge article, China appears to be at the “Ponzi Financing” stage of its “economic miracle”:
Some salient and terrifying points from Borst’s paper:
“China’s debt increased by an astounding $37 trillion between 2012 and 2022 (Figure 1). As of June 30, 2022, it reached around $52 trillion, 75 percent greater than the outstanding stock of debt in all other emerging markets combined. (For comparison, the total assets of all commercial banks in the United States was around $23 trillion at the end of 2022.)”
"A recent survey by S&P of more than 6,000 Chinese companies estimates that 90 percent of the SOEs in the sample were stuck in a debt trap, meaning they are forced to borrow more to repay existing debts."
"In early 2022, the International Monetary Fund (IMF) estimated that Chinese real estate developers had liabilities at risk of default worth more than 12 percent of GDP."
Andrew Hunt recently gave an interview, which I had to listen to 3x, given the import of the ramifications. Logan Wright’s recent paper entitled “Fractured foundations: Assessing risks to Hong Kong’s business environment” similarly gave me goosebumps. Here are some of my takeaways:
China is the most indebted country on the planet with private debt > 3x GDP. This is certainly corroborated by the charts above.
The Chinese banking system has become infinitely more opaque since 1997 and makes it difficult to find out how much they’ve truly borrowed. As Mike Green and I riffed on a Twitter Space recently, we don’t know exactly when the “Minsky Moment” comes for China, but we know it’s much closer than it was 10 years ago.
By parsing data from multiple sources including IMF/BIS data and Chinese translations of financial data from 36 Chinese banks, Andrew’s team has identified a massive $3.5-$4T “unexplained gap” versus public balance of payments data.
In particular, he notes that there are a lot of classification games around FDI numbers and discrepancies from PBOC rhetoric:
PBOC says there are ~$200B of foreign liabilities in the entire banking system, when the Bank of China alone shows $1T+.
A lot of PBOC foreign reserves appear to be as illiquid OBOR “assets” that are actually USD-denominated debt in foreign financials.
Chinese banks have effectively borrowed $4T USD at the short end of the curve to fund long-duration CNY-denominated lending into illiquid and insolvent property markets as well as ill-fated OBOR projects like Hambantota in Sri Lanka. How can China repay these debts if it can’t fundamentally recover the assets?
This has resulted in Credit Risk/Insolvency, Duration Mismatch, and Currency Mismatch — all at the same time while the Fed is poised to take US Fed Funds Rates well above 5%.
One “solution” is good old-fashioned money-printing, which appears to be China’s path of least resistance given its flagging domestic economy, still reeling from the twin fallouts from Evergrande and Zero-Covid Policies. The problem is that if the PBOC prints too much CNY to repay USD liabilities, CNY will devalue severely and invariably import the Inflation “Scylla.”
If China elects to defend against devaluation and keep the CNY strong, it will have a very difficult time evading the Shrinking Trade Surplus “Charybdis” and reviving its moribund economy. There were tells last year that the PBOC was worried about a rapid devaluation given its repeated interventions to stymie the CNY devaluation above 7 despite China’s heavy export dependence.
However, this year the PBOC Governor recently opined that the “7 level was no longer a psychological barrier.” Between this comment and the recently lowered GDP targets, it seems that priorities may have changed at the highest levels of Chinese leadership.
Some point to China’s lower cost of capital relative to the US as a sign of relative sovereign balance sheet strength. I don’t see it that way at all, but rather how badly the PBOC needs to continue flogging a “dead-horse economy.” Chinese rates have come down because of economic weakness even as US rates continue to go up because of economic strength leading to stickier-than-expected US Inflation.
@AndreasSteno I think that this masks the underlying indebtedness at the SOE level. This yield disparity to me is a sign of underlying weakness (China trying to flog a dead-horse economy) even while it masks true capital costs.Quite an interesting paper on China's leverage. "China’s debt increased by an astounding $37 trillion between 2012 and 2022 (Figure 1). As of June 30, 2022, it reached around $52 trillion, 75 percent greater than the outstanding stock of debt in all https://t.co/F8CbT9G2Qm… https://t.co/IdkrhNtI9p https://t.co/gDEephJYTa
Michael Kao @UrbanKaoboyThe CNY devaluation path could be deflationary for the world in the short-term as China scrambles to dump cheap goods on the global market in an effort to repay its debts, but these effects would also be mitigated by its own supply-chain issues and longer-term terminal demographic decline of its labor force. Short of major CNY devaluation, it’s not at all clear that Chinese manufacturing will retain the cost advantages of the last several decades.
A big problem for China is that even its own citizens don’t want to keep CNY, and any efforts to free up its capital account to encourage CNY adoption would result in massive capital flight:
As Logan Wright points out in his recent “Fractured Foundations” paper for the Atlantic Council, “As long as China’s current account for trade-related transactions remains open, capital flows are likely to take place, disguised as trade flows.”
Both Hunt and Wright think that the HKD peg to the USD is at risk of breaking as a result of this pressure. From Wright’s paper:
“The most likely alternative to the Hong Kong dollar’s peg to the US dollar is not a free float of the currency, allowing the market to set its price, but repegging the Hong Kong dollar to the renminbi.”
“As a result, such a change would place Beijing in a difficult position of needing to impose stricter capital controls between Beijing and Hong Kong or between Hong Kong and the rest of the world to prevent broader capital flight that would endanger the stability of China’s currency. China’s own “managed float” against the US dollar would similarly face peril through broad-based capital flight and diversification of Chinese savings into foreign assets.”
“China’s foreign exchange reserves are now only 8 percent of the money supply, down from 16 percent during the last period of aggressive capital flight, in 2015 and 2016.”
Andrew Hunt has similar views on Hong Hong as China’s potential Achilles’ Heel and that the entire USD-based credit system in Asia centered around China is the global Achilles’ Heel. What could the Fed wind up breaking? THIS.
Hong Kong is “horribly exposed,” with its gross exposure to China at a whopping 10x GDP and its foreign liabilities 12x its GDP! Foreign debt is $440k/working person, which makes Hong Kong 15-20x worse than Greece in 2015.
Hong Kong has already lost 25% of its FX reserves in the last few months, as it is “being stretched in the middle” between the divergent monetary paths of the US and China.
Hunt was supportive of the HKD peg until 2000. The peg made sense back then to stave off hyperinflation and also made sense because Hong Kong’s economy was 30% manufacturing and entailed buying USD-denominated raw materials, manufacturing them and then selling the goods for USD. Not any longer. The peg no longer makes sense, especially when the world of infinite QE of the last several decades resulted in a domestic debt ratio that is now 4x 1997 levels!
Hong Kong would now need a current account surplus of 100% of GDP to make good on its foreign liabilities, so Hunt does not see how the HKMA can defend HKD now, and the PBOC likely doesn’t have the USD to defend it given that China itself is very short USD.
Finally, China desperately needs to maintain its current account surplus and can’t afford to be the object of trade sanctions.
It would be a toxic brew indeed for China if both a Strong USD Policy were enacted along with restrictions on trade/investment flows, which appear to be in the offing. If there’s one issue that unites Democrats and Republicans, it is China’s flagrant and aggressive attempts to undermine the US-led RBO. Here’s a recent article that talks about potential new restrictions on investment in China:
Mark Mobius recently told Maria Bartiromo: “I'm personally affected because I have an account with HSBC in Shanghai. I can't get my money out. The government is restricting the flow of money out of the country." Nothing’s even happened yet!
Harald Malmgren and Nicholas Glinsman go so far as to say that some of these measures may make China simply “uninvestable.”
Our West Point Paper also called out state-directed IP theft by groups like Tsinghua Unigroup right under the nose of an asleep-at-the-switch Committee on Foreign Investment in the US (CFIUS). My guess is that many cross-border deals between the US/China will now be scrutinized heavily if not outright rejected.
Treasury Secretary Yellen recently warned China of “severe consequences” if China provides support to Russia in violation of US sanctions. I don’t know whether she is hinting at financial sanctions or trade sanctions, but again, rather than just default back to the same “Weaponization of the USD” tactics we used against Russia which just discourages friends and foes alike “to play in our sports facility,” why not just let a Strong USD take its course? China’s own debt-fueled profligacy of the last several decades have left it with very few degrees of freedom with which to maneuver.
This week’s rapid demise of Silicon Valley Bank (SIVB) has led many to believe that the Fed will rapidly pivot into easing mode despite continued stickiness (if not outright reacceleration) of various Inflation indicators. Sharp rallies in Gold and Bonds along with a selloff in USD all seemed to price in such a Pivot possibility when just days ago all signs pointed to the opposite — that Powell might jump back to 50-bp hikes. Interestingly, Equities and especially Financials got murdered across-the-board for fears of asset-liability mismatches causing bank runs. Hard to have it both ways, no?
In my opinion, the poor lending practices of the likes of Silicon Valley Bank and Silvergate to crypto/negative cashflow startups should not be extrapolated to GFC-like systemic risks. The borrowers represent a much narrower subset of the population and one that disproportionately benefited from decades of negative real rates and speculative froth. How does the concept of “venture debt” even pass muster without decades of Liquidity Lottery spurring massive moral hazard in lending practices involving the acceptance of equity-like downside for fixed-income returns?
Such a Pivot Scenario, while not impossible, seems highly unlikely to me. I do not believe any major banks will experience excessive fallout from the receivership of SIVB. My belief is that the economy and banking system is much more sound in the US than in the rest of the world and especially in China. As a result, when it comes to the USD, it’s not just about whether the Fed will “out-hawk” other CBs but whether other CBs will start to “out-dove” the Fed first:
The bottom-line is that China is the most vulnerable major economy to a Strong USD Policy, and if that’s what’s needed to fight what a surprisingly sticky domestic Inflation…
…beware the BALL in the China Shop — specifically the USD Wrecking Ball.
Resources:
Interview with Andrew Hunt: “Global Economy: What’s Gonna Break?”
Paper by Nicholas Borst: “China’s Balance Sheet Challenge”
https://www.prcleader.org/borst-spring-2023
Paper by Logan Wright: “Fractured foundations: Assessing risks to Hong Kong’s business environment”
West Point Paper I co-wrote: “US Dollar Primacy in an Era of Economic Warfare”
Re: Geopolitics/Inflation/USD-Ball In A China Shop.
Fair points, but it was a choice for them to 1. Not hedge their rate exposures, 2. Allow for an uninsured deposit base of over 90%. Imho, THAT was the forcing function that led to the run.
Thanks for this article.
I felt able to absorb this content, even though I am a macro economics neophyte.