Will China's Credit Bubble Finally Pop? Maybe

ZeroHedge had a couple of important stories about Chinese credit growth and the slowdown in that growth today.

China Bond Yields Soar To 9 Year Highs As It Launches Crackdown On "Off Balance Sheet" Credit
And while we are confident Chinese financial geniuses will find ways to bypass this attempt to curb breakneck credit expansion in due course, in the meantime, Chinese liquidity conditions are certain to get far tighter.

This is precisely the WSJ reported overnight, when it observed that yields on Chinese government debt have soared to their highest levels in nearly nine years amid Beijing's relentless drive to tighten the monetary spigots in the world's second-largest economy. "The higher yields on government debt have pushed up borrowing costs broadly, creating obstacles for companies and government agencies looking to tap bond markets. Several Chinese development banks, which have mandates to encourage growth through targeted investments, have had to either scale back borrowing plans or postpone bond sales."

Yesterday, they posted this: Chart Of The Day: How China's Stunning $15 Trillion In New Liquidity Blew Bernanke's QE Out Of The Water

This is nothing new here. What is new, however, is the government's serious efforts to slow this growth and the fact that since it's a couple years since I first discussed this, the number of assets has grown by more than 100% of GDP. It doesn't the bubble will pop, but it has been 5 years since the financial crisis. I mentioned in Will 2014 Be The Year That Changes Everything?, we are right on schedule for the depression within the depression.

Risk of 1937 relapse as Fed gives up fight against deflation

Here's a long snippet from Shades of 1935 In the FOMC's 'Tapering'? discussing the Federal Reserve's decision to tighten in 1935, though not implementing a policy until 1937.
The justifications for these efforts were varied, but included the board's opinion that banks were disproportionately investing in government bond securities at prices that may not have been sustainable beyond a record low rate environment. The Fed also felt that such excess in reserves might lead to "over borrowing" in such close proximity to the over-indebtedness (Irving Fisher's term) of the previous collapse. They also paid attention to a seemingly partially formed theory that the condition of reserves signaled to foreign investors that the US was "ripe for speculation", and thus causing gold to flow into the US - the very root of the reserve "imbalance" in the first place.

Whatever the inflationary concerns of the FOMC, it acted in July 1936 by raising the level of required reserves. Not to be satisfied with that, the committee also instituted two other reserve changes in early 1937, as well as coordinating with the Treasury Department as it began sterilizing gold inflows in much the same manner as in the late 1920's. In its August 1936 Annual Report, the Federal Reserve noted, "the Board's action was in the nature of a precautionary measure to prevent an uncontrollable expansion of credit in the future."

Almost immediately, banks responded in a manner wholly unanticipated by the FOMC. Rather than suffer a decline in their liquidity buffer, banks busily endeavored to reinstitute their level of excess reserves. The pace of buying credit securities halted immediately, and by December 1936 banks were outright selling corporate and government bonds. Between the first reserve requirement change and the end of the year, new corporate bond issues declined by almost 50% in number - collapsing still further into 1937.

From the onset of Treasury's gold sterilization, corporate bond yields in what we now would call "junk" jumped from about 4.5% to 6% by the end of 1937. Even investment grade corporate debt rates spiked, from about 4% to 5.25% (these are large moves in credit markets of the time).

Industrial production peaked in December 1936, then fell slightly until September 1937 when the economy collapsed again. From the peak, industrial production fell more than 37% in just a few months. Factory employment dropped 25%, while department store sales (the primary retail outlet) declined 16% - the disproportionate declines in production owed to the excess of inventory from business investments in 1936 and early 1937.

In short, 1937 and into the trough in mid-1938 was a depression within a depression. We have never seen such close proximity of depressionary episodes, nearly back-to-back, in history. And it occurred without the backdrop of monetary and banking panic. There was no appreciable increase in bank failures, and certainly nowhere near what was seen in the over-covered part of the 1930's.
Here is what is very crucial to understand in comparing the 1930s to today: the Fed stopped the first wave of deflation, whereas in the 1930s, the first wave came in 1929 and quickly rolled into wave 3 in 1931, the "Tragic Year" in which most economists were looking for recovery. The collapse that year came as a shock to the world. By 1937 then, the system was already mostly cleansed of bad assets. The depression within the depression was a surprise, but it was different from the prior two waves in its real world results. Today, the risk isn't of a 1937-style contraction, it is the risk of 1931, the shock wave three deflation that levels the global financial system.

The 1937 deflation also was blamed on bad fiscal policy. The Affordable Care Act is not as direct as the tax changes in 1937, but it could end up being as damaging to the economy. That said, China is the real story. It is China that is in the position of the 1920s and 1930s United States. China did pursue the strategy used by Japan in the 1930s of having the government flat out spend and finance it with debt. It is China that is already implementing policies to tighten money supply. If the U.S. and China "coordinate" their monetary policies and both tighten, the odds of China's credit bubble bursting goes from possible to likely.

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