China's Volatility Machine

In Michael Pettis' book, The Volatility Machine: Emerging Economics and the Threat of Financial Collapse, he argues that emerging markets are prone to volatility and collapse due to pro-cyclical financial development.

Here's how I interpret his views with a bit of Austrian economics thrown in, and then relating it to China. The economic cycle of many emerging markets is nothing more than a resource/credit boom. The poorly managed nations of the world that we often see in Africa and Latin America are trapped in the boom-bust cycle because they do not have long-term growth plans, they simply ride the cycle. Capital from developed economies is funneled into malinvestment and the bust inevitably follows. The end result is the economy gains no ground on developed economies, losing nearly all the gains made during the boom. There is no convergence with the developed world.

In East Asia and outlier nations such as Chile, an escape from the cycle of boom and bust is achieved through development—each stage of boom brings the society to a higher level of development from which the bust does not shake it. However, these nations are still greatly affected by the regional and global credit conditions: the timing of the boom is often not of their making, nor is the bust. These nations experience huge booms and busts when they develop pro-cyclical balance sheets, and weather the storm very well when they enact counter-cyclical policies. Some are leveraged to their own boom or hedged against it.

Will Globalization Go Bankrupt?

As is often forgotten during credit and investment booms, however, monetary conditions contract as well as expand. In fact, the contraction is usually the inevitable outcome of the very conditions that prompted the expansion. In times of growth, financial institutions often overextend themselves, creating distortions in financial markets and leaving themselves vulnerable to external shocks that can force a sudden retrenchment in credit and investment. In a period of rising asset prices, for example, it is often easy for even weak borrowers to obtain collateral-based loans, which of course increases the risk to the banking system of a fall in the value of the collateral. For example, property loans in the 1980s dominated and ultimately brought down the Japanese banking system. As was evident in Japan, if the financial structure has become sufficiently fragile, a retrenchment can lead to a collapse that quickly spreads throughout the economy.

Since globalization is mainly a monetary phenomenon, and since monetary conditions eventually must contract, then the process of globalization can stop and even reverse itself. Historically, such reversals have proved extraordinarily disruptive. In each of the globalization periods before the 1990s, monetary contractions usually occurred when bankers and financial authorities began to pull back from market excesses. If liquidity contracts — in the context of a perilously overextended financial system — the likelihood of bank defaults and stock market instability is high. In 1837, for example, the U.S. and British banking systems, overdependent on real estate and commodity loans, collapsed in a series of crashes that left Europe’s financial sector in tatters and the United States in the midst of bank failures and state government defaults..

China need not be an example of a pro-cyclical economy. It is a large economy that can develop a large internal market. It relied on exports for growth in the 1980s and 1990s, but a growing domestic economy could shift growth into a consumer economy less reliant on global trade flows. Instead, China built itself into a massively pro-cyclical economy headed for an historic bust by eschewing a consumer economy and relying mostly on government directed investment and a credit fueled property sector.

Global trade rises and falls with global booms and busts. As Pettis notes in the article above, and as socionomics argues, during periods of negative growth, people turn against free trade. Global trade doesn't ebb and flow with the economy, it surges at the peaks due to new trade deals and it collapses at the troughs due to protectionist policies. Trade is very cyclical by itself.

Trade is a larger portion of small economies' GDP. The United States has a large trade deficit due to the size and structure of its economy, not due to the size of its trade. If global trade were to drop to zero tomorrow, the U.S. would be among the least affected nations in the world, while highly trade dependent nations such as Korea would see their economy collapse by 50% (exports are more than half of GDP). As emerging economies grew larger in the past 15 years, they became a larger portion of China's total exports. These same nations are increasingly dependent on Chinese demand for raw materials, such as copper, coal, iron ore and oil, either directly or through the higher prices caused by China's growth. Thus a self-reinforcing (pro-cyclical) trend emerges: China relies on exports to emerging economies that grow quickly because of Chinese demand for raw materials, which causes Chinese exports to increase.......and on and on.

China still relies on trade because its currency is still mainly tied to the U.S. dollar. If China does not increase its holdings of U.S. dollars (or if it does not add some other asset such as gold), then the value of the yuan will fall.

What is driving China's growth besides exports, especially since after 2008 the European, American and Japanese economies have almost no demand growth? Infrastructure development driven by a credit boom in China, helped along by loose monetary policy in the United States, Europe and Japan. The Chinese created huge amounts of credit and built infrastructure, be it government directed investment or privately build commercial and residential real estate. This investment boom fueled another spike in commodity prices and lifted growth in emerging market economies. Additionally, China's credit creation far outstripped the amount of U.S. dollars flowing into the economy and Chinese businesses also borrowed U.S. dollars because the yuan is appreciating. In sum, China is massively short the U.S. dollar.

Meanwhile, China's sovereign wealth fund and state owned companies invested in commodities. Deals for natural resources and farmland were made all over the globe. Billions in investments in economies and sectors closely tied to China's own growth rate, fueled internally by a credit bubble of historic proportions. On top of that, when bankers began to get nervous about extending credit, they asked for collateral. That collateral often takes the form of copper, iron ore or steel—the value of which is tied to the Chinese economy. Or it is backed by real estate, the value of which is tied to the credit boom and demand from which supports commodity prices.

China Faces "Vicious Circle" As Commodity Collateral Collapses
About 40 percent of the iron ore at China’s ports are part of finance deals, Mysteel Research estimates.

This makes China's economy very fragile. Even without these commodity backed loans, China's economy is at risk from a downturn in commodity prices that weakens demand in emerging economies. With these loans backed by commodities in place, commodity prices are now at risk from Chinese loans souring. If these commodities flow back into the world market, it will be the very trigger event for China's own bust.

On top of all this, much of the shadow banking credit flowed into investments in coal mines and real estate, the former of which is tied to global commodity prices and the latter to China's credit boom.

In conclusion, China has experienced a very long boom phase thanks to reckless lending taking over from 2008-2013, when global growth slowed. Instead of developing an internal market and making counter-cyclical investments, China bet everything and then leveraged up in order to bet on the China/emerging market/commodity cycle.

The one big counter-cyclical asset on China's balance sheet is its vast holdings of U.S. Treasuries. It is one asset that will surge if there is a global emerging markets crisis. Gold will likely be another. Considering the Chinese are likely to devalue the yuan if a deflationary crisis breaks out, those Treasuries and gold holdings will allow China to avoid a complete currency collapse—but it still may devalue the yuan by a significant amount by the end of the bust. That will set the stage for the next great boom......

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