How Do You Say “Minsky” in Mandarin?

Wikipedia defines a Minsky Moment as, “a sudden major collapse of asset values which is part of the credit cycle or business cycle. Such moments occur because long periods of prosperity and increasing value of investments lead to increasing speculation using borrowed money. The spiraling debt incurred in financing speculative investments leads to cash flow problems for investors. The cash generated by their assets no longer is sufficient to pay off the debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. This is likely to lead to a collapse of asset values. Meanwhile, the over-indebted investors are forced to sell even their less-speculative positions to make good on their loans. This starts a major sell-off, leading to a sudden and precipitous collapse in market-clearing asset prices, a sharp drop in market liquidity, and a severe demand for cash.”

GDP grew faster than credit for years during China’s Economic Growth Miracle.  But since the financial crisis, when policymakers opened the credit spigots wide open, “the bubble has become so big that sustaining it requires twice as much money as the real economy needs,” per Stephen Roach via Caixin.  Roach claims that for every three yuan of monetary increase, two go toward sustaining the bubble. In the first quarter of this year for example, total credit growth in China accelerated to north of 20% – more than double the pace of GDP growth.  This gap has been widening for more than a year, as illustrated in the graphic below.

SG Chinese Credit Growth

China’s credit growth has outpaced nominal GDP growth in every quarter except one since 2009.  Perhaps more concerning is the recent trend of more rapid credit growth (red line) driving even slower economic growth (blue line), with the economy now slowing to levels last seen in the wake of Lehman’s collapse.  In other words, the excess borrowing that occurred to “avoid” the financial crisis has not been absorbed by the real economy, yet more debt is being piled on top of this today.

Another difference between the surge in credit today and the one which occurred in 2009, is the increasingly perilous structure of China’s debt, as noted in Ponzi Finance.  Bank loans accounted for most of the initial credit surge, but the shadow banking system has supported spiraling debt since 2012.  While loan growth barely accelerated beyond 15% last year and has actually dipped entering 2013, trust loans have more than doubled in the past twelve months. Per SG, “The ever-greater role non-bank financing has played in this credit cycle has clearly increased the vulnerability of China’s already burdened financial system.  A fast rising debt load of an economy suggests either deteriorating growth efficiency or high and rising debt service cost, or in many cases both.  There is clear evidence that China is suffering from both of these.”

Liquidity is the pillar of China’s financial system and the only thing hiding the extent of the economy’s bad debt. Since the Fed began its recent Taper Talk,  that liquidity has dried up, leaving China vulnerable to a squeeze as hot money runs for the exits. We view the recent credit crunch as yet another indication of long term issues coming home to roost.  For additional perspective on these events, we turn to Michael Pettis, one of the most well-connected and brilliant China rock-stars we know.  Here’s an excerpt from China Financial Markets:

Last week interbank rates suddenly soared, to well above 13% by Thursday. It seems that the markets were more or less frozen late Thursday. There were also rumors that at least one bank defaulted on its payments. 

It seems that the big banks began hoarding liquidity on worries that their short-term interbank loans would not get repaid. Because big banks were afraid to lend in the interbank market, the market froze up. I think the intervention of the PBoC Thursday night consisted mainly of telling the big banks to stop their hoarding and to lend again.

I suspect the PBoC never expected this to happen the way it did and they were caught as flatfooted and confused as everyone else. Until last year they have never had to deal with a stable or even contracting money supply, and consequently they have had little experience in dealing with these kinds of conditions.

That no one really seems to know what happened clearly isn’t good for the markets. In fact, to be cynical, when liquidity is plentiful, interest rates are low, and the markets are soaring, the limited availability of credible information may even by a “good” thing because it allows us plausibly to put forward some very optimistic interpretations of whatever information we do have. 

It is when market sentiment turns negative that we see the real cost of a lack of transparency. When investors and businesses are nervous, they are likely to over-interpret bad news and to fill in knowledge gaps with the most alarming of the various plausible scenarios. Lack of transparency, in other words, is a kind of positive feedback mechanism that exacerbates volatility.

The good news is that the new administration seems far more determined than the previous to rein in credit growth and restructure the economy. The bad news is that the credit system is so distorted and over-leveraged that any attempt to rein in credit growth creates enormous stress in the system.

Chinese financial markets often seem less volatile than one would expect for a poor, developing country, largely because of administrative measures that intentionally or unintentionally suppress normal volatility. These kinds of systems, however, are not less volatile. They seem less volatile because small shocks have minimal impact. Larger shocks, however, tend to cause a much greater than expected surge in volatility.

Going forward we will probably see more of this in China. Volatility will be suppressed for periods of times only to erupt in greater than expected volatility from time to time. This is not only a China problem, of course. One can easily argue that the Fed’s actions under Alan Greenspan seemed to induce a “great moderation”, but only temporarily, and when the great moderation became less moderate, the economy was always likely to be more disorderly than expected. The euro, similarly, sharply reduced volatility in peripheral Europe for many years until it suddenly exacerbated it. Of course no student of Hyman Minsky would be surprised by any of this.

“Such moments occur because long periods of prosperity and increasing value of investments lead to increasing speculation using borrowed money. The spiraling debt incurred in financing speculative investments leads to cash flow problems for investors.”  Such “cash flow problems” are beginning to rear their heads.  It’s a good time to re-read Pettis’ Volatility Machine and bump The Great Rebalancing towards the top of the wish list.