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On the Chinese Minsky Ladder, again…

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redflag_2· China, credit and banks

The unsustainable credit bubble in China during H1, which is perfectly consistent with the Hypothesis of financial instability, may very well remain one of the main themes of this note, with all the consequences such a “journey’ implies for financial markets and macro scenarios.


In any case, one thing is for sure: it will remain a major source of volatility. In effect, it is already hard to identify the culminating point of credit overinvestment euphoria in Western economies, so it is just all that must harder in a command oriented economy. As such, we will need to continue monitoring certain domestic indicators, such as money supply, credit, imports, overcapacities), but also statements by officials, who seem to have as much taste for falling stock indices as they do for demonstrators filling Tiananmen Square. Given the pace of new account openings by individuals on the stock market (700,000 per week in July), we had better keep a close eye on the situation.

We have emphasised the determination of bank regulatory authorities to require financial institutions to strengthen their capital, by excluding hybrid securities in cross-holding agreements with other banks which offer no real guarantee against systemic risk, should the hike in non-performing loans granted in recent months turn “toxic”.

An example of the consequences of this policy was provided by China Merchants Bank, which just announced that it must increase its new share issue 22% to 20bn yuan to comply with the new capital adequacy ratio requirements. The bank’s share shed 6.26% this morning, down 30% for August.

Although it is not possible to date and quantify the correction of asset prices in the Middle Kingdom, it is important to try and determine the global consequences of such a movement.

· China and commodities

We already know that China is responsible for a good part of the rebound in commodity prices since the beginning of the year, with its imports dedicated to infrastructure projects and the build-up of strategic reserves, and indirectly, because the surge in imports was used to persuade investors to “ride the wave” via dedicated ETFs or OTC contracts. If this movement were to slow down – and the example of Chinese peasants stocking zinc and copper on price speculation leads me to believe that the movement has hits its apogee – the impact on commodity markets would be colossal, given the absence of Western demand to pick up the slack.

We note ironically that government held Chinese firms (SOE) are getting set to authorise the unilateral with Western investment banks, if they trigger what they view as unacceptable losses. This implies that the latter will have to neutralise their hedging and, thus, trigger a decline in commodity prices, which would lead, as usual, to the above-mentioned investors withdrawal from this asset class, which has not turned out to be so great, after all.

· China and world trade

One of the dramatic consequences of the “Great Recession was the collapse in world trade, which remains a problem today, as testified by the steeper decline in imports compared to exports in Japan, the US and Europe month after month. China was one of the only countries in the world to react differently, as can be seen in the following statistics concerning the hike in imports from its trading partners in Q2: South Korea +26.6%, Taiwan +41%, Japan +30.2%, EU +23.5%, US +11.5% !

For example, Kia Motors posted a 52% hike in auto exports to its neighbour in Q2, while AU Optronics’ (LCD flat screens) imports rose 40%. As such, if domestic activity were to slow down, there could develop a second round of disinvestments from its trading partners, especially if their utilisation capacity rates remain extremely low. It is worth noting that the Baltic Dry Index, an advanced indicator of trade volumes, which plunged 94% (!), from 11,700 to 679 in H2 2008 and then rebounded to 4,291 in H1 2009, has taken a new 45% correction since the beginning of June, and now stands at just 2,241.

· China and Deflation

We have long characterised this zone as the world’s deflation exporter, something Western consumers have understood for quite some time. You may recall the virulence of the debate in 2005 about the export of women’s bras to the United States. In an economy whose own officials recognise that they are confronted with extreme overcapacity (cement, steel, glass-making), this trend, instead of diminishing, is likely to worsen. The first victims of this phenomenon are the country’s closest neighbours, who are required to adapt as China climbs the scale of finished goods, while still relying on much cheaper labour. The first country to suffer is obviously Japan, whose lost two decades were not just the result of its initial errors in monetary and fiscal policy, but also due to the deflationist black hole represented by the neighbouring Chinese economy. BoJ Governor Mr Shirakawa had some soothing words this morning in this regard:

“There are concerns about falling prices but he said he does not believe that Japan will plunge into a deflationary spiral, under which falling prices cause sharp wage cuts, which in turn depress prices further.

His words lack punch, as Japan publishes average wage income in July, down 4.8% y-o-y, the 14thmonthly decline in a row. But we can understand the political tenor of this denial of a deflationary spiral, especially since his other comments are much more lucid:



As the yen returns to its record highs against the dollar, at 93 this morning, with the yuan being linked to the dollar, this is becoming problematic … And if the only global inflationist fear today – the level of certain commodity prices – were to burst, as we believe, it is more than likely that the debate about negative interest rates (deposits) would pick up steam, with the UK following in the footsteps of Sweden, then the US, followed by …

· Consequences for markets

We continue to believe that the stock market rally, understandable when short-term rates are at 0% (extension of capitalisation multiples), but difficult to reconcile with our macroeconomic scenario for the coming years, is not worth betting on, except for trend-follower investors, to the extent that they are vigilant enough to know when to pull out.

We saw huge Eurostoxx options strategies, for the first time in a long while, implement very final equities hedges for a total nominal amount above €1.5bn. One of the alerts signals will thus remain Chinese markets, not because of their flow of share trading worldwide, but for all the macroeconomic consequences discussed above. AS for European government fixed rate instruments, although we would prefer taking advantage of a slight correction to suggest new downward interest rate strategies, we remain positive on this asset class, which has come out of the last six months fairly unscathed on stock markets.


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