Centralised systems have done everything possible to pursue stability at all costs increasing the probability of a large failure. Like the Fed, the Chinese have tried to stabilize their system and now may have to pay the costs

Well, it finally happened. After over seven months of threatening and stalling the US Federal Reserve finally announced its famous taper. Ben Bernanke, chairman of the US central bank, the Federal Reserve (Fed), said that the Fed would reduce its bond buying by $10 billion a month until the program is terminated in about seven months. Contrary to many expectations, markets surged. Bernanke softened the blow by providing “forward guidance”, which is basically a conditional promise not to raise interest rates for the foreseeable future. So despite many fears, it appears that the Fed has pulled it off. They have promised to end the program without too many problems. Or did they?

Despite the promises and the market optimism, is there a reason for concern? Is there some sort of ‘black swan’ out there that can spoil the party? When Bernanke first breached the idea of tapering, emerging markets crashed along with their currencies. While many emerging markets are off their October highs, they haven’t totally collapsed. But many of their currencies have.

This is especially true of the so of the so-called ‘fragile five’ emerging market economies – Brazil, Indonesia, Turkey, India and South Africa – are regarded as the most vulnerable because of their current account deficits. The Brazilian real dropped 1.2%, while the Korean won slipped 0.9 % and the Turkish lira neared an all-time low against the dollar, falling to TL2.077 in early evening trading, down 0.8% on the day.

Turkey is especially vulnerable. It depends on short term capital flows to finance more than to finance more than 80% of its high current account deficit. So it is especially vulnerable to an outflow of hot money. The central bank has only about $42bn in net reserves – equal to around two months of imports. It could raise interest rates to stem the tide, but it is subject political pressure from Recep Tayyip Erdogan, the Turkish prime minister. He and his party accuse the bank of a conspiracy. They accuse the bank of being controlled by an ill-defined “interest rate lobby” is trying to restrict Turkey’s growth.

Turkey’s problems could certainly cause a ruffle in the global markets, but there is another much larger problem: China. Two weeks ago I wrote about the possibility and dangers of China and the Fed tightening simultaneously. Apparently, it is occurring.

Since June, the Chinese leadership has been trying to slow down speculation. Its central bank, the People’s Bank of China (PBOC), has been restricting liquidity by refusing to inject cash into the banking system, sometimes with dramatic results. Their first effort occurred in June. The result was a spike in Chinese interbank lending rates. They spiked to double digits and at one point rose as high as 28%. At the same the Shanghai Composite Index suffered its steepest drop in more than three years, falling 5.3% to 1,963. The markets recovered after the PBOC injected funds into the system, but the process is continuing.

At the end of October the PBOC again refused to inject money into the system for two weeks. When they finally did, it was at higher interest rates.

But it didn’t stop the speculation. The proposed reforms announced in November have made things worse. China saw a sharp rebound in credit, particularly from its unregulated shadow-banking sector. It added 624.6 billion Yuan ($103 billion) in new loans in November, up 118.5 billion Yuan ($19 billion) from October and 102.6 billion Yuan from the same period last year. A broader measure of new loans called total social financing hit 1.23 trillion Yuan ($202 billion) in November up sharply from 856 billion Yuan ($140 billion) in October. So-called ‘hot money’ is pouring in. The combination of deregulation, rising interest rates and a strong Yuan is irresistible to the carry trade, which views it as a one way bet.

To regain control the PBOC has refused to add liquidity over the past few weeks. Their actions exacerbated a regular year end scramble for cash as the banks attempt to comply with regulatory requirements and large demand for refinancing from many borrowers unable to repay their loans.

As the panic spread, the Shanghai Composite fell by 2%. The nine-day decline for Chinese stocks was their worst in nearly two decades. Last Friday, interbank lending again spiked by over 100 basis points in just one day to 7.6%. It has risen from 4.3% in a single week. At this point the PBOC panicked and announce over the Chinese version of Twitter that it was going to inject Rmb200bn ($33bn), a large amount. Under its normal rules the PBOC does not announce injections until a month after the fact.

Will this problem persist? According to analysts at Barclays, there are several reasons why it will. These include deposit rate deregulation, which will drive up funding costs; the PBOC’s tightening bias as it attempts to reign in the rapid credit growth since 2009; competition from the shadow banking system including wealth management products (WMPs) and now even internet companies like Alibaba whose internet banking product, Yu’E Bao, has been garnering one twelth of every Yuan deposited in the banking system since June.

Finally, and most dangerous is the irrationally high pricing of some of these alternative investment products. These rates are artificially high because so far there have not been any defaults to alert issuers to be rational and depositors to be careful, until now.

Last week, Liansheng Resources Group, a big player in the Chinese coal industry, applied to a court in Shanxi province to restructure its 30 billion Yuan ($4.94 billion) debt, in short, a default. At least one billion Yuan ($164 million) of this debt was sold to investors by one of China’s shadow banking trust companies. This investment product paid 9.8%, but was backed only by personal guarantees. Most products are backed in theory by collateral, but in a country where the law doesn’t work all that well, claims on collateral might not be all that safe either.
 

Liansheng Resources is not the only company in China to borrow at excessive rates. Many other companies have as well and many will be in the same position of defaulting on their debts as the PBOC tries to drain money from the system. Money returning to the US as interest rates normalise will certainly not help.

Defaults and cash crunches are definitely not what you want to see in a sound financial system, but are they enough to cause a crash? Are they a Chinese ‘black swan’? Only time will tell, but as Nassim Taleb points out the centralised system that has done everything possible to pursue stability at all costs increases the probability of a large failure. Like the Fed, the Chinese have tried to stabilize their system and now may have to pay the costs.

(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.)