Another month, another $100 billion in burned foreign exchange (FX) reserves in China. I say ‘burned’, but what I really mean is a combination of capital flight from China and the People’s Bank of China selling US dollar-denominated assets to defend the yuan from further disorderly devaluation. You can see why I said burned. It’s a lot more direct.
China still has $3.2 trillion in FX reserves. But you can see from the chart below, that’s down from almost $4 trillion at the start of 2014. At this rate, China could bleed reserves for another three years. But you have to wonder just how much money would already be out of the country if capital controls weren’t in place.
If another yuan devaluation is on the cards, its puts pressure on the competitiveness of other Asian economies. Once the great engine of global growth, China becomes the great force behind global deflation. That depresses commodity prices, emerging markets and oil, and drives capital into a narrow band of assets (high quality government bonds and blue chip stocks).
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The moral of the story
If you haven’t seen The Big Short yet, I’d recommend it. It’s entertaining. It takes a story about complex financial instruments and turns it into an understandable story about human beings and the decisions they make about risk with other people’s money. Those decisions are bad.
There were two points I took away from the movie. First, it wasn’t the subprime mortgage debt that created systemic risk. True, the nominal size of the debt was considerable. And the people who treated the debt like high quality government bonds were either misinformed, lied to or stupid.
But the losses from defaulting mortgage-backed securities would have been contained to the investment banks or commercial banks that chose to buy the securities. It was the collateralisation of that debt, and then its distribution to thousands of balance sheets throughout the world, that made it a systemic problem.
Even then, it would have been a lot of people taking losses. They would have managed. And the weak financial hands that couldn’t manage would have been wound up through existing legal bankruptcy procedures. Why didn’t that happen?
In order to make ‘the big short’ on the US housing market, the bears had to convince Wall Street to invent a security they could buy. It was the credit default swap. The credit default swap provided insurance against a default in mortgage bonds. Wall Street took to the idea of selling default insurance on housing-backed bonds like a pig takes to…slop. No one thought the US housing market could crash. Ever.
Collecting premiums (cash) from policy holders is, after all, a great business — provided you’ve correctly assessed/underwritten the risk. Wall Street didn’t care about the risk that mortgage bonds would blow up. Some of the investment banks (like Merrill Lynch and Lehman Brothers) owned the bonds. But there was too much money to be made selling default insurance. It was free money. And you could sell as much as anyone wanted to buy.
Once Wall Street realised the underlying mortgage debt was toxic, it refused to re-price the value of the default insurance to reflect the decline in the value of the mortgage-backed bonds. In fact, for a while it refused to re-price the bonds, despite rising delinquent payments and defaults in the actual mortgage market.
You can do this in an opaque market where there isn’t continuous pricing and liquidity. But at that point — as some of the traders with short positions found out — it’s not really a market. Because it wasn’t a market, Wall Street could properly position itself for the fall it knew was coming. Which means it could put the investing public in place to take the fall.
That was probably the most devious, ethically questionable and possibly illegal thing the banks did. Once they realised they either owned a lot of high-risk mortgage debt, or they had sold insurance on a lot of debt that was going to default, they did everything they could to offload the bad debt to unsuspecting buyers and establish their own short position.
Once they did that, it was safe to let the rest of the world know how bad things really were. Not only was it safe, it was necessary. That would trigger an incredibly profitable trade.
The last point I took from the movie is that very little has changed since 2007. The European Central Bank, for example, is busy trying to backstop the market for collateralised debt in the European banking system. It’s their preferred method for addressing undercapitalised banks in Italy. Package up the bad debts, slap a guarantee on them and sell them!
There’s nothing new under the sun. The only difference between now and 2008, is that the explosion in debt has expressed itself as $29 trillion in corporate borrowing. Low interest rates and bad monetary policy are at the root of all credit bubbles. You never know where the money is going to go. But it always goes somewhere.
This time around, nearly $5 trillion went into financing the US shale boom. The rest? Share buybacks, mergers and acquisitions, and the odd dividend payment. This debt may not be interest rate sensitive or house price sensitive in the way mortgage-backed bonds and collateralised debt obligations were. But ask yourself if the financial and banking systems are more stable and less risky now than they were eight years ago.
EU Ministry of FML
Oh, by the way, the head central bankers in Germany and France have published a newspaper article in Germany calling for a eurozone ministry of finance. ‘Although monetary policy has done a lot for the eurozone economy, it can’t create sustainable economic growth,’ wrote Bundesbank President Jens Weidmann and Bank of France Chief Francois Villeroy de Galhau, in an inspired moment of honesty and humility.
Naturally, the Franco-Prussian alliance has suggested another centralised European Union (EU) institution to make up for the failure of centralised monetary policy. An EU ministry of finance — presumably in charge of coordinating a common fiscal policy for eurozone members — would produce growth in ways that monetary policy is currently failing to do so. Maybe by spending helicopter money.
Please note that not every member of the EU is a ‘eurozone’ country. There are nine countries in the EU that don’t use the common currency: Bulgaria, the Czech Republic, Denmark, Hungary, Poland, Romania, Sweden and the UK. It is one of the Prime Minister’s aims — in his attempts to secure better terms of surrender to the EU — to ensure countries in the EU but not in the ‘eurozone’ aren’t bullied, browbeaten or otherwise subdued.
Good luck with that. The Axis-of-Centralisation wrote in their article that:
‘The current asymmetry between national sovereignty and communal solidarity is posing a danger for the stability of our currency union. Stronger integration appears to be the obvious way to restore trust in the euro zone, for this would favour the development of joint strategies for state finances and reforms so as to promote growth.’
In a way, you can understand their point. They are committed to a European project with greater political and economic centralisation. They want solidarity. Not exemptions and qualifications.
Britain wants the old deal. The one it agreed to in 1975 with a common market and free movement of people, goods and services. The other, Margaret Thatcher and the Tories supported.
The current negotiations are a farce. The Prime Minister is pretending to ask for things of substance. In the meantime, the drivers of the EU project in Berlin and Brussels are deadly serious about a federal Europe with more integration, less national sovereignty and greater control of national budgets.
And don’t even get me started with the ‘War on Cash’. That’s happening alongside this pretend negotiation. The aim is to make a deal that gives the Prime Minister some of what he asks for. But not really to change — not one iota — the driving force behind the whole project: ever closer Union and more control over you and your money.
Ed Note: This article was first published in Capital and Conflict.