Chinese Wealth Management Products Will Cause the Next Financial Crisis

BY CHRIS MAYER
POSTED 
NOVEMBER 6, 2014

The next financial crisis will begin in China.

This will be the event in financial markets when it happens. In this letter, I’ll tell you about the trouble spots and ripple effects. More importantly, I want to steer you clear of them.

Please read on…

“Troubles in China Rattle Western Banks,” says one Wall Street Journal headline. “String of fraud cases and problem loans stings foreign lenders as Beijing investigates executives, seizes assets,” says the subhead.

A few big European banks recently were on the losing end of a $475 million loan, thanks to fraud. The best part of the story was this quote:

There is plenty of evidence of recklessness in China.

“It was a surprise to all the banks. We didn’t know,” said one executive at a Western bank with direct knowledge of the matter. [Italics added].

“We didn’t know…” Of course they didn’t know. How could anyone suspect there would be fraud in China? Let’s see, there are only about half a dozen lenders involved in a suspected fraud case at Qingdao Port. Those lenders are in for a billion dollars. There’s also the case of Nomura. It lent $60 million to a Chinese shoe company just months before the CEO disappeared… along with the money.

Sarcasm aside, there have been several cases of late. Yet the story I started with was a C4 story buried in the middle of The Wall Street Journal. I want to make the case to you that these kinds of stories will work their way to the front page in 2015 — and why it matters.

To make my case, I draw primarily on two expert witnesses. The first is Yan Liang, an associate professor at Willamette University. She gave a fascinating presentation at the Post-Keynesian Conference I attended in Kansas City in September.

The focus was on the shadow banking system. You have probably heard the term “shadow banking” tossed around and wondered what it was all about. The definition can vary, but generally, a shadow bank is a lending institution that does not have the public backstop that normal banks do. (Read: a lifeline from the central bank.) They can also use greater leverage and evade certain regulations.

In China, shadow banking has quadrupled in size since 2008. Lending is not a business that grows that fast without doing reckless things. There is plenty of evidence of recklessness in China.

Liang focuses on the so-called trusts and wealth management products (WMPs). These are vehicles you can invest in that will then pay you a higher interest rate than a bank deposit will. The problem is people tend to think these are as safe as bank deposits. In fact, owning them is about as safe as swallowing a box of nails.

Trusts, for instance, use a lot of leverage. The average is about 40 times for the largest trusts, Liang says. (See the chart above.)

To show you how fragile a 40-times leverage ratio is, let me use an analogy. Imagine you owned your house at 40 times leverage. That means for every $100 of value in your house, you have just $2.50 of your own money in it. In such a case, just a 2.5% drop in the value of the house means you suffer a 100% loss of your equity.

And it is not like the trusts are investing in super-safe stuff. They make risky loans in infrastructure, real estate and industries with excess capacity. Also, they are opaque. Liang says that “only 29 out of 66 registered trusts disclose capital, and most (except for two publicly listed trusts) failed to report returns.” I imagine the ones not reporting are not proud of the results.

The wealth management products are just as bad. To an investor, they look like time deposits. But they pay higher rates because they take your money and invest it in risky loans to small businesses. Worse, Liang says that shadow banks often issue new WMPs to pay off old ones and dodge reporting bad loans. It’s like a big Ponzi scheme.

In fact, a Chinese regulator, Xiao Gang, did call them a “Ponzi scheme” last year in public. (Amazing that he still has a job. People who say stuff like this tend to wind up behind bars.) It’s easy to hide these things in China. Banks “often act alone in originating, distributing, custodying and managing WMPs,” says Liang. There is no independent party monitoring these things.

The maturity of WMPs is also getting shorter. So in 2007, only 10% of WMPs matured in less than 90 days. More than half were at least a year out. By the end of 2010, about 40% matured in less than 90 days. And less than 20% had maturities longer than a year. “But the funds raised could be invested in long-term projects, such as real estate,” Liang says. “So again, liquidity risk is excessive.” In other words, many WMPs hold long-term assets such as real estate on 90-day financing. Crazy.

Add to all this the fact that companies in China are having a hard time making money. The nearby chart, from Liang’s presentation, shows China’s corporate sector performance. The trend is bad. More and more companies are losers (almost 18% of the sector). And the median return on assets (or ROA) has fallen to under 3%. Weak. And these data are a year old. We can only guess where the numbers are now.

At this point, to further bolster my case, I’d like to call Charlene Chu to testify. I heard her talk at Grant’s fall conference. Her title was “Crash, Boom or Muddle? Casting China’s Future.”

Charlene Chu is the head of Autonomous Research Asia, started in Hong Kong in September 2014. Before that, she was a director at Fitch in Beijing, where she worked for eight years. Chinese banks were her beat at the rating agency. And before that, she worked for the Federal Reserve Bank of New York.

“The China today is not the China of before the financial crisis,” Chu began.

If you go back to the early 2000s, China’s was a banking sector in which there were hardly any other investment alternatives. Everybody put their money in the bank, Chu said. Every bank offered the same interest rate. You had no incentive to move your money from one bank to another. And there was no property market. There was barely a stock market. Chinese banks had virtually no liabilities.

That’s all changed today. Echoing Liang, Chu showed that China has a debt problem.

In her analysis, Chu did not care much for GDP growth, which most people focus on. She said it was the “most politicized number in the economic world right now, and it is not that informative.”

Instead, she focused on the massive loan growth in China. For six years in a row, China’s banks have extended net new credit. The total is an “astonishing amount.” If put in U.S. dollar terms, “we’re talking about $5 trillion of credit being extended for six years in a row.

“Under those kinds of circumstances, I think any country in the world would be growing at a very rapid rate,” she said. “The real question we should be asking about China is why isn’t growth stronger?”

China is slowing down, despite massive credit growth. She called into question the big and wide divergence between the picture in the financial data from banks and what is happening on the ground.

“I was in Beijing a couple of weeks ago,” she continued. “Across the board, everybody is expecting a slowdown.”

To answer the question she posed in her presentation, “Crash, boom or muddle?” she quickly dispatched one scenario. “I don’t see any case for a boom.” Neither do I.

Chu says China will muddle. In the Q&A, she did allow that if it got really bad, the Chinese authorities might have to make choices about who they bail out. Foreign bank claims might, in such a case, get the old shaft.

Commodities China buys heavily… would seem to be vulnerable to disappearing demand.

Meanwhile, stupid foreigners (mostly banks) have been lending money in China as if a boom was a given. Lending rose 47% in the 12 months ending in June, says the Bank for International Settlements. China is also the largest emerging-market borrower by far.

Liang also goes for the muddle-through scenario. “State-owned banks dominate China,” she said, “and the central government has the capacity to write off bad debt and recapitalize banks. Think the late 1990s.”

I will dissent from my esteemed China watchers. Markets don’t work so neatly. Big credit problems don’t go quietly into the night. Authorities, even Chinese ones, have no magic wands to wave and make problems go away. Markets boom and bust. I think China’s bust will be nasty and shake global markets to the core.

I would treat Chinese investment ideas as if they have Ebola. Some supposedly smart investors (this means you, GMO!) are bullish on Chinese banks. They cite, among other things, a low price-to-book ratio. But I agree with Chu: “The price-to-book ratios for Chinese banks are not low when you realize that 50% of the capital could be impaired in a very short amount of time.”

Stay away from China. Stay away from firms lending money in China. Those are easy steps. More difficult is to predict the ripples a financial crisis in China would create. Commodities China buys heavily — like iron ore, oil, copper and potash — would seem to be vulnerable to disappearing demand.

I have no doubt China will be a much bigger economy in 10 years’ time. But that doesn’t mean investors have to make money, especially foreign ones.

Regards,

Chris Mayer

Source: Daily Reckoning

Follow us on Twitter: @blacklioncm

The Real Reason the U.S. Dollar Has Value

BY CHRIS MAYER
POSTED APRIL 8, 2014

I was at a conference when I took out a dollar bill and waved it in front of the audience. I asked, “Why does this piece of paper have value?” It’s interesting the range of answers I got.

One person said “gold,” which has nothing to do with it. There was a time when you could demand a fixed weight in gold in exchange for a dollar, but those days are gone. Another said, “You can buy things with it” — an answer that only begs the question why that it so. “Faith,” said yet a third. Not quite.

The answer is one that (some) economists have known about for a long time. I’ll tell you about it below along with three other counterintuitive and seemingly bizarre conclusions about the twisted world of modern money. I don’t think you would draw it up this way if you had the chance — but it’s the way the system works.

Government debt… is a form of savings for the private sector.

Tax liabilities give otherwise worthless paper value. The U.S. dollar has value because the government levies $3 trillion in tax liabilities annually and accepts only U.S. dollars in payment — which only it issues. And there is the credible threat of penalties if you don’t settle up with dollars. In so doing, the government turns all of us into dollar chasers. It’s how a state, any state, can turn worthless pieces of paper into valued currency.

“The modern state can make anything it chooses generally acceptable as money,” economist Abba Lerner wrote in 1947. “If the state is willing to accept the proposed money in the payment of taxes and other obligations to itself, the trick is done.” Brilliantly devious, isn’t it?

A dollar is, essentially, a tax credit. Economists call this the tax-driven view of money, and it is at least as old as Adam Smith. It is also one of the core principles of Modern Monetary Theory, or MMT. (This is a macroeconomic school of thought that has taken the deep dive into the plumbing of how modern money works.)

The principles of MMT have a certain forceful logic. And they can lead to some shocking and uncomfortable conclusions…

One example is that government deficits increase financial savings. It sounds outrageous. How can government deficits increase savings? Well, how else is the nongovernment sector supposed to get dollars? The only way is for the government to spend more than it collects — thereby leaving money in the economy.

Or think of it this way, as economist Warren Mosler puts it: “When the government spends, only two things can happen to that money… the money can be used to pay taxes, or it isn’t used to pay taxes. In which case, somebody out there still has it.” So deficit spending equals financial savings at the macro level.

Government debt, then, is a form of savings for the private sector. Everywhere there is a Treasury security there is someone who owns it. For that holder, it is a part of his financial wealth, or savings.

But aren’t government deficits and debt too large? They can be too large, which then causes the dollar to lose value. However, in a fiat currency system, it is natural for the government to be in deficit, because the private sector usually wants to save something.

In fact, there is a good argument that any attempt to balance the budget is futile. It will simply lead people to cut spending in an effort to get back to a desired savings level. This also has the effect of contracting the economy and driving tax receipts lower, thereby putting the government back into deficit.

The trouble with budget surpluses is they take money out of the economy. That puts pressure on private-sector balance sheets. It may not be so surprising to learn, then, that economic depressions have followed every major surplus in U.S. history.

Another conclusion is that Government doesn’t need taxes and bond sales to finance spending. Most people think that the government collects taxes and sells bonds to finance its spending. But remember, the government issues dollars. It can’t run out. This sounds scary, but it’s the naked truth of a fiat currency system. The U.S. government faces zero solvency risk. It can always meet all of its bills.

Of course, there are consequences when government spends. If it spends “too much” relative to what dollars can buy and the desire to save, then the dollar can lose value. (Which is what’s happened over the last century. I see no reason why this trend will end.) But the government clearly doesn’t need to borrow or collect something it issues in order to spend. That’s the point.

Further, think about it from the beginning: What must a government do before it collects its own money in taxes? It has to spend the money first. That’s how people get the dollars to meet the tax. So logically, spending precedes tax collection.

There is a classic paper by Stephanie Bell (now Kelton) that demonstrates that “proceeds from taxation and bond sales are technically incapable of financing government spending” and that governments actually finance their spending by creating money directly. (See “Can Taxes and Bonds Finance Government Spending?”). It’s a bit technical, but I believe it is correct and I mention it here in case you want to hunt it down. It’s free online.

There is another key insight that follows from this.

The U.S. government never borrows from the Chinese to “finance” its budget deficit.

The U.S. government is not at the mercy of foreign creditors. You’ve surely heard that the U.S. is in debt to China, because China holds some large amount of U.S. Treasury debt. Politicians even used this rhetoric around election time, saying how we are borrowing from the thrifty Chinese to pay for our lavish lifestyle.

It’s not true. And in fact, it can’t be true. Let me cite economist L. Randall Wray, who put it in no uncertain terms:

Those who claim that the U.S. government must borrow dollars from thrifty Chinese don’t understand basic accounting. The Chinese do not issue dollars — the United States does. Every dollar the Chinese “lend” to the United States came from the United States…. The U.S. government never borrows from the Chinese to “finance” its budget deficit.

Again, think through how the Chinese got the dollars. They sold stuff to Americans. Presumably, they did this because they wanted to acquire dollars. That can change, and the foreign exchange value of the dollar will change, too, to reflect the desire of foreigners to hold dollars. But the point I want to make is simply that the U.S. issues dollars; China and other foreign governments do not. Therefore, the U.S. doesn’t rely on foreign creditors to finance its spending.

As I told you, the world of modern money is a seemingly bizarre world, but it does have its own logic and principles. I’ve only touched on a few of the most surprising conclusions here. (I would humbly suggest that the best introductory guide to this monetary maze is Wray’s Modern Money Theory: A Primer on Macroeconomics for Sovereign Money Systems.)

At least you have a good answer why the U.S. dollar has value — albeit, a value that bleeds out over time. It’s a currency, not an investment vehicle.

Regards,

Chris Mayer
for The Daily Reckoning

Source: Daily Reckoning

Follow us on Twitter: @blacklioncm