Since the fog of the financial crisis of 2007-2008 descended upon global markets, I have been waiting for the events that I expect will be central to global financial performance in 2016. The Crisis masked three fundamental realities that have taken almost a decade to move into focus.
- US bankers and their regulators - about which I kvetch regularly here in SA - are, in spite of their shortcomings, the best the globe has to offer. The other major players, such as Europe, the BRIC nations and Latin America (excluding Mexico) are a distant second and rapidly falling.
- The most significant reality creating the crisis is the poor quality of European banking and bank regulation, a key enabler of the irresponsible lending and financial engineering in the US that is commonly assigned blame for the Crisis.
While there is no question that the US mortgage/financial engineering debacle deserves some of the blame, Europe, the runner-up in quality of financial governance among the three major country types identified here, has gradually shown its banks' inferiority to those of the US.
Worse, Europe suffers today from increasingly weak governance as Germany unwisely strives to force its will on Southern European fiscal policies. Through time, the greater significance of poor European banking quality, compared to American greed, has been increasingly evident.
A close second in importance as a source of global weakness is the bad judgement - often corrupt, but always about control by the few in power - of industrial and financial policies in the less developed world, centered on the BRIC countries - most prominently, China. China seeks a prominence in global financial markets it does not deserve, and this will be its undoing.
Europe: Behind the attention-getting United States-originated blunders at the onset of the Crisis - due to US federal government obsession with housing and investment banker obsession with financial engineering - lurks the great enabler for US financial excess, a fundamentally weak European banking and bank regulatory sector, too easily exploited by US dealer banks. As has become clearer over time, much of the risk originated in the US was "stuffed" (sold on) to European financial institutions, explaining why the bailouts of banks by governments in Europe have been slower to unwind. Many European banks are still partially owned by the governments in question or government shares are being sold at a loss. The US government is out of the bailout business at a profit.
While the United States was selling mortgage-backed snake oil in the lead-in to the crisis, none of it would have been possible without a collection of European banks that are fundamentally without their own ideas about generating profitable financial opportunities. A reminder of the attitude of European Banks toward their fiduciary responsibility came with the suit against several US banks brought by Commerzbank (OTCPK:CRZBY) reported by SA here on Christmas day.
Banks in Europe remain dependent on partial government support and highly leveraged, compared to US banks. To a degree, the recovery in the United States is hindered by the bank regulatory burden here, put in place in response to the Crisis. But the European banks are in worse shape and will find lending more difficult in 2016. European regulators have also been slower and less effective in pressing the banks to change, which will further prolong the European malaise.
In addition, Europe's industrial sector has been slowed by austere fiscal policy dominated by Germany.
But industrial regulation, even banking regulation, in Europe compares favorably to that of the rest of the world (excluding the smaller players, Australia, Canada, and New Zealand.)
China: China is also finding the twenty-five years of promising a reduction in the share of government-owned industries in their economy difficult to keep.
This is the year of the unmasking of the China's pretensions to financial dominance. The drivers of the unmasking are China's blindness to its own unfolding issue, the need to transition from a rural to urban country, and its hubris.
Ironically, the wire may have been tripped by the IMF's inclusion of the renminbi yuan in the SDR. The announcement of the IMF's decision drove analysts into three basic camps.
- One group of analysts thought that this was the beginning of China's ascendancy to global financial primacy. They did include a stipulation that China would have to keep its promise to liberalize and decontrol markets. Good luck with that!
- Former Fed Chairman Bernanke, in a more tempered response, found in SA here, awarded China a "gold star" for inclusion. Simultaneously suggesting the country's global position in financial understanding was about grade school level, but also suggesting this IMF's encouragement was a good thing.
- The third group were the sceptics. I voted this way in my SA article, "The Renminbi Yuan: Is Importance a Curse Or A Blessing?" The point of the title that SDR inclusion would be a curse for China, not the blessing it sought. By focusing international attention on the currency it would draw attention to its fundamental lack of soundness, and the hollowness of Chinese governmental assurances of greater liberalization.
"...the Law of Unintended Consequences, stronger than any written Law. 'Whether or not what you do has the effect you want, it will have three at least you never expected, and one of those usually unpleasant.'"
This IMF decision simultaneously highlighted China's hubris and the IMF's judgement. I caused me to propose (with my tongue firmly in my cheek) that the dollar pull out of the SDR. Without the dollar, the SDR would be falling like a brick (no pun intended). This first week of the New Year, we are looking at the beginning of a global revaluation of currencies of tectonic proportions.
Short the yuan and the Euro for at least the next year.
China financial analysts know Chinese prices and economic statistics may be of somewhat dubious veracity. Yet they do not always focus on the fundamental dishonesty of Chinese policymakers that this implies.
And the basis for Chinese growth, bridges and trains to nowhere and empty buildings, is becoming a matter of doubtful long term judgement. China is saddled with the fundamental weakness of planned economies, compared to market economies. The unintended consequences of plans, particularly government plans, are almost always more significant than the intended consequences. The Chinese plan - to change from an investment/debt oriented economy to a consumer oriented economy - like that of Japan before it, has a hollow ring.
What will this Chinese long term weakness mean for American markets? See Jeff Miller here for a thoughtful answer. The short run is uncertain. The long run effects of China's problems, no one can determine. Like any control economy, the best guess it that China's ship will be righted, but at permanently lower growth rates than those of the recent past. The downside, however, is immense.
The United States' strength and that of the dollar in particular rests on the three pillars of our financial system: competence, rule of law, and prevention of authoritarian rule.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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