måndag 29 februari 2016

World financial markets in the middle of a countdown

These days, barely half a day goes by, without me thinking about what the hell is going on in the economy. Like I wrote (in Swedish) not long ago I believe a very deep financial asset repricing (downwards) and recession is just around the corner, but I can't understand what is keeping it from happening right now.

After reading this fantastic article I am more reassured than before, the repricing (crash) will happen. Many investors seem to agree, but then there is a big cadre of pundits who say: "I cannot see a crash, in fact, the financial markets are going up this week". So vocal investors are split in two camps, and the majority is probably sitting on the sidelines, not trading at all, waiting to see what happens. No one, including western central bankers appears to have a clue about what is going on, or at least the central bankers are not telling the markets. Therefore I have been trying to come up with explanations about the wait for my self, below is one of the that I believe the most in.

It is all China

Since the early nineties China, after entering the World Trade Organisation, has been exporting cheap goods to the West utilising a seemingly infinite supply of cheap labour. Farmers moved to the cities and became factory workers. In the West we believe that a low inflation environment is here to stay, I can see only two explanations to why inflation has been so low for so long:

  1. Cheap Chinese labour and goods have been a deflationary force
  2. Adoption of new technologies also is a deflationary force

I believe the Chinese force has been the strongest, 1.5 billion people industrializing is a very large force, it only took them about 20 years or so. As China exported vast amouts of goods abroad, tremendous wealth was created in China. 

Since China has got a fixed exchange rate against the dollar, which is managed by the Chinese central bank, the Chinese central bank had to buy foreign financial assets with the foreign currency proceeds from all those exports to prevent the Yuan to appreciate against the US Dollar. In this process, the Chinese central bank and consequently government (communist party) gained control over huge foreign exchange reserves. In other words, China purchased huge amounts of financials assets in the West pushing up asset prices and pushing down interest rates on everything.

$4 trillion is just a huge number by any standard, for example the US economy is $17 trillion. So a big number has a big impact, a big deflationary impact. You know, "cheap Chinese goods" is not just a saying, it probably is heavily deflationary. 

And by the way, I like to write huge in this article since the sums are so huge. It does not really matter what central bankers in globalised small countries like Sweden and Switzerland do, they have no power, there is too much capital swoshing around cross broders. Living in Sweden, I think we just have to ride the roller coaster of world financial markets.

Trouble in China

For some reason that I do not know, the Chinese economy seems to have lost steam. Their stock markets have had scares recently and there are reports of huge Chinese bad debts. As a consequence, Western investors are selling Chinese assets like crazy. To maintain the fixed exchange rate against the US Dollar, the Chinese central bank has to sell their foreign assets fast to keep their currency from depreciating against the US Dollar, since investors are selling Yuan-denominated assets. Just over a year after reaching $4 trillion the foreign exchange reserves of China are down to $3 trillion, a huge move. Given the size of the sell-off of Western financial assets, by China, that could have resulted in a crash already, but instead the Federal Reserve, the ECB and most other western central banks have been busy buying financial assets, perhaps keeping asset prices from crashing, more famously known as QE (or quantitative easing). 

A very good graph from a recent Economist shows how the net balance sheet change of the Federal Reserve and the Chinese central bank combined has been increasing until now, pushing up asset prices, but for the first time it is contracting. That is probably putting pressure on prices of financial assets downwards, as we have seen, Western stock markets have been hesitant during 2016 so far.

The countdown

For as long as Western central banks keep buying the foreign exchange reserves that the Chinese are selling all seems stable. However, when China no longer have more foreign exchange reserves to sell, then something happens. The Chinese currency might devalue considerably and who knows what might happen to asset prices or inflation in the West. 

Graph of the Chinese countdown / foreign exchange reserve, time is ticking, when does China run out of money? 

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