derryl

Global Markets in Review: Are Markets Discounting Bernanke's Scenario?

I'm interested in your comparison of China's market cap to the US. I doubt that Mark Mobius' prediction of China's cap exceeding the US in 3 years will come true, but I think it's clear that China is trying to generate a wealth effect among its people to kickstart a domestic consumption market.

China told its banks to LEND! and they did, far surpassing their quotas for new loans. A lot of this money found its way into the stock markets and pumped them up (I don't know the numbers for real estate so I won't comment). This money did not go primarily into IPOs or additional stock offerings. That is, the money did not go into funding new productive ventures or expansions. It went into buying stocks at rising prices from people who already owned those stocks.

This puts lots of cash in those sellers' hands. They are "wealthy", and newly wealthy people tend to want to upgrade their consumption lifestyle to reflect that, as we saw with Americans who used their rising house values as ATMs to live rich. Even Chinese who didn't sell their stocks feel wealthy at current and rising valuations, so the wealth effect is present in China.

When I first heard about China ordering its banks to lend and the resultant stock market rise or inflation or bubble I was mystified. I don't think Chinese are stupid. Had they learned nothing from the US experience? Now I see that they did learn from the US. They learned how to use the wealth effect of rising asset valuations to accelerate domestic consumption. They may be deliberately inflating asset bubbles toward this end.

The lever is credit creation, and they are pulling it hard. They are pumping money into their economy. Both the M and V of Friedman's formula are at high levels, so we can expect either or both Q and P to rise with them.

That is, China's economy will be seeing some combination of output increases and price inflation as a consequence of this MV acceleration. With all the slack production capacity that opened up due to the collapsing export markets I don't think CPI inflation will be a big Chinese problem just now, so they should see significant output increases to meet rising domestic demand.

Considering individual bankruptcies as a macro economic factor, when highfliers come crashing down due to overleveraged ambitions, the result is that banks write off the debt and recover some fraction of the debt amount by selling the collateral asset. So (using US$ terms instead of yuan) if a bankrupt owes his bank $500k and the bank sells the foreclosed collateral for $300k, there is now $200k of 'owned money' in the economy.

Bank loans are money creation and repayment of bank loans is money destruction, so if borrowers put their $500k into the economy by buying a house from someone then take $500k out of the economy to repay their loan, the net 'owned' money they add to the economy is zero. But if a borrower defaults then the $500k is already in the economy, and the important thing is that the money is owned by someone other than the bankrupt borrower and the bank cannot get it back from its present owner. The bank takes the writeoff and the money stays in the economy.

My point is that the Chinese leadership may be well aware that they are blowing bubbles that will collapse, and that collapsing bubbles leave lots of 'owned' money in the economy even as borrowers go broke and banks take loan losses. Some win, some lose, but in macro you end up with much more money circulating in your economy that is not owed to your banks as repayment for loans. The banks wrote off the debts but the people who sold stuff to the borrowers still get to keep the money.

Basel II notwithstanding, bank solvency and how you deal with it is an issue for national regulators. Bankruptcy is a political decision, not an arithmetic necessity. Large US banks were not dissolved recently just because massive asset devaluations rendered them technically insolvent. China can support its insolvent banks if its purpose is to increase the amount of money circulating in the Chinese economy in order to build up a domestic consumer market.

This is a longer term process, of course. The same process the US followed since 1913, with all those 'business cycles' of booms, busts, bankruptcies and debt writedowns by banks. The Chinese may have learned the US lesson very well.

The State of the Banking System

There are lots of smaller regional banks who never drank the derivatives Koolaid. There are lots of business and personal loan customers who still make all their payments on time because they are not terminally overleveraged. There is still a solid, core banking industry at work in America.

A recent SA article linked to an interview with one of these prudent regional bankers who was asked (by the OCC and FDIC, I think) to take over a failed competitor and his bank was willing and able to do so, and happy for the opportunity to speed up his expansion plans. All the 'meltdown' tumult and shouting involved the big money center banks who were rescued with taxpayer billions. Plenty of smaller bankers also played Wall St (i.e. played the higher risk, higher return Ponzi banking fiasco) and lost because they weren't too big to be liquidated. But for literally thousands of US banks business goes on more or less normally. I'm sure many of these bankers would take on a piece of Citi's business.