End to stimulus in the offing?
While it is always possible that the Fed and the Chinese government could continue to inject money into the system, there are very good reasons why they might refrain. An uncoordinated tightening by the worlds' two largest economies appears to be a definite possibility, which may have very unfortunate consequences
Since the beginning of the recession monetary policy around the world has been very similar: the more money the better. Without any particular agreement the US, Japan, Eurozone and China have all been flooding their economies with stimulus. This may soon change.
As I wrote last week, the Federal Reserve has been considering tapering since May. Until recently most market pundits have predicting that put the beginning of the taper off would not occur until next March. The Fed and Janet Yellen have specifically stated on many occasions that the beginning of the taper will be data dependent, and the data has been rather good. The numbers definitely puts the probability of a taper closer perhaps December or January. The best indication of an earlier taper is the yield on the 10 year US Treasury note. It reached a high of 2.97% at the beginning of September only to fall back to 2.48% a month later. Since then it has been rising. It is now up to 2.86% a level not seen since the Fed declined to taper in September. The jobs report and the unemployment numbers were also very good and within what the Fed once described as its goal for ending quantitative easing (QE).
The Fed constantly tries to remind the markets that a taper is not tightening. Certainly the bond buying program will go on for months after the taper starts. It might even change to the purchase of short term two and three year notes as the Fed policy changes. In fact unlike the 10-year, the rates on the shorter term notes have declined over the past few weeks. Still as it did in June any taper is likely to have an impact on overheated global markets.
A rate increase by the Fed would be bad enough, but it might get worse. Apparently the Chinese are also tightening. The process is far from transparent, but there is no doubt that recently interest rates in China have been going up. The yield on the government 10-year is at 4.6% the highest since 2008. The Chinese government recently auctioned $3.3 billion worth of 50 year bonds at a yield of 5.31% the highest since 2009 and over a hundred basis points above the yield in the last auction. The seven day repo rate rose 25 basis points. Last month money market rates jumped to their highest level since June when the People’s Bank of China (PBOC) drained a net 15 billion yuan ($2.4 billion) from the system.
While it is always possible that the Fed and the Chinese government could continue to inject money into the system, there are very good reasons why they might refrain. Recently there has been a lot written about bubbles. This is really beside the point. It is always difficult to determine a bubble. It is not hard to determine risk. The Federal Reserve has been clear about this. They wanted to encourage risk. Sure enough if you flood the world with money, a lot of it will be lent to people who might not pay it back. The Fed and the PBOC may not worry about bubbles, but I am sure they are concerned with excessive risk and there is a lot of that.
The record stock market is just one indication in the US. There are many others. They include mREITs, which I discussed in my last piece, plus record issuance of securitized assets, so called cov-lite loans, a record margin debt and a new record for the issuance of triple C rated junk bonds. Janet Yellen and her colleagues are concerned about unemployment, but they are also concerned about excessive risk as illustrated by Fed Governor Jeremy Stein famous speech last February.
The concerns of the Fed are small compared to those of China. No one knows exactly, but the best guesses place Chinese municipal authorities’ debt at 9.7 trillion yuan ($1.6 trillion) or 14% of all loans. According to a November report by Moody’s only 53 percent of the 388 municipalities had enough cash to cover debt payments and interest this year without refinancing.
Much of the money for municipalities and real estate development was raised through the Chinese shadow banking system. The size of the credit in this system has exploded. It grew by roughly 14 trillion yuan ($2.3 trillion) in the first 10 months of 2013. Nearly half of all new credit creation is from non-bank institutions.
China’s banking system is more dependent on regulations than market interest rates. This is supposed to change, but until it does, the PBOC is also tightening by changing the rules. In a regulatory move that will help dry up credit, the PBOC has placed new limits on interbank lending. Interbank lending exploded because it has allowed banks to avoid regulator limits. Interbank assets have increased 140% over the past three years and has more than tripled for mid tier banks. The new rules could reduce the tier one capital by 1% and lending by 5%.
Recently when either the Chinese or the Fed either started to tighten or even hint that they would soon pull back, there was an immediate strong reaction. Not just in the US and China, but also in the emerging markets. This reaction might have sapped their resolve. However the markets did not learn any lessons from the temporary pull backs. When stimulus was resumed or tightening no longer threatened, the speculation resumed with a vengeance.
While neither the Fed nor the Chinese seem concerned about bubbles, they surely are not blind to the unintended consequences of their actions. Janet Yellen has even complained about the Fed as a prisoner of its own policies. So an end to stimulus seems definitely in the offing.
Perhaps either the Chinese or the Fed might be able to slow down their stimulus programs without a crash, but it appears though that they might be doing it at the same time. Since neither institution has been particularly good at revealing their intentions, it is not only the market that is in the dark. Both institutions are not totally cognizant about the other’s intent. So an uncoordinated tightening by the worlds’ two largest economies appears to be a definite possibility, which may have very unfortunate consequences.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)
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