And just like the U.S. in 2008, China in 2014 is looking down the barrel of a Minsky Moment: The point at which servicing debt levels becomes unsustainable, and there are no reserve cushions large enough to absorb the losses.
Lots of people are pointing this out; Mish Shedlock had a piece about it this morning, and he and others are right to worry that a shadow banking collapse will be bad for China.
But it will be even worse for the U.S.: Because after all—unlike the United States in 2008—China in 2014 has the reserves to buy its way out of the hole it’s in.
In 2008, the U.S. shadow banking sector began its collapse when real-estate backed bonds turned out to be a lot dodgier than originally thought. This set off a systemic domino effect. We all know how the Global Financial Crisis of 2008 (GFC) played out.
Now, what did the U.S. Treasury and Federal Reserve do when the GFC hit? In other words, what did the American government do in the face of a collapsing financial sector?
Why simple: It threw money at the problem. But it was money that the U.S. government and Federal Reserve didn’t actually have . . .
The Treasury launched the Troubled Asset Relief Program (TARP), the $700 billion bailout of American banks.
The Federal Reserve launched QE (Quantitative Easing (QE), and its various subsequent iterations, eventually “expanding its balance sheet” (i.e., printing money) by some $3 trillion and counting; and implemented the Zero Interest-Rate Program (ZIRP), which meant that if you factor in inflation, the Fed has been paying banks to borrow money since 2008—and will continue to do so through at least 2015, as they have already announced.
So in other words, the U.S. Federal government went into massive debt to save the banking sector (TARP); and the American central bank essentially debased the currency (QE, QE II and III, as well as ZIRP).
All of this was to clean up the mess left by the U.S. shadow banking sector, and protect the wider economy from the knock-on effect.
TARP and especially the Fed’s machinations were considered “heroic measures” when they were implemented. Why “heroic”? Why so very novel and unorthodox (or so very orthodox if you’re from Zimbabwe or Argentina)?
Simple: Because neither the Treasury nor the Fed had ready cash to pay off the clean-up.
But China doesn’t have that problem. China has been a net creditor to the world. The Chinese government and the Chinese central bank have plenty of money on tap, in case needed.
Right now, China is sitting on some $1.3 trillion in U.S. Treasury bonds, not to mention a host of other liquid assets. China’s government and central bank have the ready cash to pay off the collapse of their shadow banking sector.
I’m not arguing that Chinese authorities were any wiser than their American counterparts, in allowing the explosive growth of the shadow banking sector and a surefeit of debt. What I am arguing is, unlike the U.S. in 2008, China has the tools to get out of this hole relatively easily.
But what effect will this have on U.S. Treasury bonds?
Well, it will depend on how the Chinese authorities decide to clean up their shadow banking mess.
(BTW, unlike in America, the Chinese will probably be ruthless with their shadow bankers—executions are definitely in the offing. Witness what happened a few years ago with the melanin-in-powdered-milk scandal: The responsible people were tried on a Monday, found guilty on Tuesday, and put in front of a firing squad I do believe that very afternoon. (Don’t you just wish American lawmakers had done the same to Dimon, Blankfein, et al.?) The Chinese, they don’t mess around.)
China’s shadow banking sector has exposure to both internal creditors and external (foreign) creditors. In the case of the former, if push comes to shove, the People’s Bank of China (PBC) can simply nationalize the shadow banking entity which has gone broke, then print enough renminbi to settle any counterparty claims, without this renminbi-printing noticeably affecting its exchange rate or the PBC’s balance sheet. The PBC certainly won’t hesitate to nationalize and unwind a teetering bank (as the U.S. should have done—but didn’t—in the case of Citibank), especially if such nationalization will restore internal confidence.
In the case of Chinese shadow banking entities with foreign exposure, the PBC can sell Treasuries to get dollars to pay off those foreign claims—and here we come to the nub of the issue.
If a major holder of Treasuries—such as China—all of a sudden decides to unload a big chunk of said holdings in order to get dollars so as to pay off a broken financial sector, what effect will that have on Treasury bond prices?
See why China’s current shadow banking problems matter in America? If China’s shadow banking sector is visited by a version of 2008’s GFC, Treasuries will take a hit, as the PBC sells them in order to get the hard currency to pay off foreign creditors.
An obvious objection to this is, Why would the Chinese honor foreign obligations of its shadow banking sector, especially if that entity is broke? After all, it allowed bond holders of Chaori Solar—the first Chinese shadow banking bonds to ever default—to eat the losses.
The obvious answer is, in the face of a single bond or entity’s failure, the Chinese government and central bank will proclaim caveat emptor—but in the face of a systemic collapse (such as what almost happened in the U.S. in 2008), the Chinese will shore up their shadow banking sector, no different from what the U.S. did, and for exactly the same reasons: A system-wide collapse would have devastating social and political consequences that would be far more costly than simply bailing out the shadow banks.
If and when the Chinese shadow banking sector collapses, the exact same potential outcome—generalized economic collapse—will be more than enough incentive for Chinese authorities to nationalize the sector and make their creditors whole.
(And this points to a corollary: It might be a shrewd investment to pick up some extra-cheap Chinese shadow-banking products once the sector looks on the verge of system-wide collapse. The warning, though, is that the buyer has to know when the Chinese shadow banking sector looks to be on the verge of systemic collapse—and pick products from entities that the Chinese government will not allow to fail, or at least not allow to default.)
How will the American Treasury and the Federal Reserve react to a Chinese sell-off of Treasury bonds to pay for a shadow banking bailout?
My thinking? Federal Reserve Chairwoman Janet Yellen will print and buy—in other words, more QE, which as I’ve said more than once is nothing but gasoline thrown on the unlit bonfire that is dollar hyperinflation.
I have two books out, which I hope you will enjoy: Hyperinflation In America is a look at how hyperinflation could take off, how to prepare for it, and how to invest so as to take advantage of it. The other is A Secret History of The American Crash, which explores the social and sociological effects of a prolonged, catastrophic failure of the American economy.
Click on the links to check out free samplers of both books. Thank you, and enjoy! GL
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