The tectonic plates of the world economy are shifting in opposite directions. China is winding down fiscal stimulus very quickly and will be in soft-slump conditions by the middle of next year; the U.S. is on the cusp of overheating.
This unfamiliar mix will kill off the “Goldilocks” era that has so seduced us. It is likely to catch the analyst fraternity off-guard, judging by the “macro forecasts” for 2018. Goldman Sachs may have to paddle back on oil and copper. A global commodity boom with China on the sidelines is hardly possible. The Chinese central bank (PBOC) is keenly aware of the danger. It has drawn up a contingency plan, fearing that China may be compelled to “shadow” rate rises by the U.S. Federal Reserve and tighten interbank lending into the teeth of a downturn.
The PBOC is fretting about a “grey rhino” scenario where disastrously timed tax cuts by the Trump administration – at the top of the U.S. economic cycle, with the broad “U6” jobless rate at a 16-year low – will provoke a more ferocious retort from the Fed than markets assume. Traders have priced in one rate rise next year. What if U.S. core inflation spikes and the Phillips curve comes back to life, and there are instead four rises? Adam Posen, from the Peterson Institute, thinks the dollar index (DXY) could blast towards 110. If that happens, the tightening shock would hit East Asia with the force of a sledgehammer.
“Asia’s sweet spot looks stretched to us and we warn of a rising risk of a potentially painful snapback. High debt leaves it exposed to a global repricing of credit risk, possibly triggered by inflation surprises,” said Rob Subbaraman from Nomura. “We believe that 2018 will be the year that China starts to address its moral hazard problem. We see a greater risk of a spike in credit defaults and capital flight,” he said.
Capital Economics says its proxy gauge of Chinese output has dropped to 5.2 per cent from a blistering pace of 6.6 per cent in July, and is likely to slow to 4.5 per cent next year. China’s fixed asset investment has already begun to contract in real terms. The slowdown is heading for levels that set off the recession scare in 2015. The Fed quietly came to the rescue on that occasion by suspending rate rises: this time the U.S. cycle is far more stretched.
Let us assume the Republicans pass US$1.4 trillion of unfunded tax cuts for the next decade, with “front-loaded” stimulus adding 0.8 per cent to America’s GDP growth in 2018.
Let us assume too that U.S. corporations repatriate a fifth of their estimated US$2.6 trillion of offshore funds to take advantage of a one-off 14 per cent tax holiday, whether switching from euros, yen, etc into dollars, or switching the money from the offshore dollar funding markets to the U.S.
Either sends a powerful impulse through global finance. Despite the rise of China and the creation of the euro, the world has never been so dollarized, or so highly geared to U.S. lending rates. The Bank for International Settlements says offshore dollar funding has risen fivefold to US$10.7 trillion since the early 2000s, with a further US$14 trillion of global dollar debt hidden in derivatives. BIS research suggests that the ups and downs of the dollar – and the cycle of dollar liquidity – are what drive the world’s animal spirits and asset prices. This liquidity spigot is clearly being turned off. The Fed is not just raising rates, it is also reversing bond purchases.
We will learn in 2018 just how much tolerance there is for an aggressive Fed and a dollar squeeze in a global economy where debt ratios have risen to a record 327 per cent of GDP, up from 276 per cent a decade ago, and this time emerging markets have been drawn into the quagmire as well.
My guess is that tolerance will be low. It is hard to see how the “everything bubble” could survive 100 basis points of rapid tightening.
Needless to say, the Fed will reverse course if there is carnage on the equity and credit markets for fear of blow-back into the U.S. economy. The world will be saved again. But first you have to have the carnage. The wild card is China. Its breathless “stop-go” lurch from boom to bust, to boom again, is nearing its limits. The once inexhaustible flow of rural migrants into the cities has dried up, knocking away the key prop for housing. Capital Economics says total demand for square footage peaked in 2013 and will decline 5-10 per cent per year from now on. A sector that once powered 16 per cent of Chinese GDP faces atrophy. Government spending has stepped into the breach. The International Monetary Fund thinks the “augmented fiscal deficit” hit 12 per cent of GDP this year, including spending by the regions.
The blast of stimulus over the last two years matches the post-Lehman spree in 2009. It is the chief reason why the global economy has sprung back to life, which raises awkward questions over what happens when it goes into rapid reverse.
The latest spending was political, culminating in a crescendo of infrastructure projects months before the consecration of Xi Jinping. Growth pulled forward from the future propelled Xi into the Communist pantheon alongside Mao. His thoughts now have constitutional status.
This has been a Faustian pact: the future eventually arrives. Non-financial debt has galloped up to 300 per cent of GDP. Yes, the banking regulator Guo Shuqing has been clamping down on shadow banking since February. This has hit smaller private firms the hardest. They face a credit crunch. There has been no such discipline for the state-owned behemoths (SEOs) that gobble up most bank loans. Xi’s pledges to cleanse these instruments of patronage have come to nothing. He needs them too much to maintain the iron grip of the Communist Party.
It is possible for a state-controlled banking system to roll over bad debts almost indefinitely. What it cannot do so easily is to conjure away funding problems. The mid-tier banks rely on short-term market finance to cover 34 per cent of lending, mostly on maturities below three months, like Northern Rock and Lehman. This is why the IMF has warned of a “funding shock” and a fire-sale of assets in a broken market if liquidity ever dries up, and why the PBOC’s governor has been muttering about a “Minsky moment.”
China has large foreign reserves and exorbitant domestic savings. It can weather a bout of stress. Whether those dependent on the Chinese economy are so well protected is another matter. What is certain is that “everything bubbles” will not survive the U.S. tightening cycle of 2018.