Bank loan rates temporarily spiked in China in the middle of last month and Fitch issued an ominous report on the country's debt with the situation. The situation was well explained by Ambrose Evans-Pritchard.
The spike in interest rates, most notably the seven-day repurchase rate and the Shibor, is indicative of what I refer to as the "simultaneous collective epiphany", the point at which everyone realizes all at once that there is a problem.
Since then, however, the interest rates have fallen back and the crisis that appeared imminent appears also to have passed -- for now. But what's been done can not now be undone. In the words of Maya Angelou: "The first time someone shows you who they are, believe them." The same may be said of markets.
One of the prime drivers in market action is confidence gaming, which takes two basic forms. The first is what most of us are familiar with -- the markets and the preference of the media and society for good news and optimism. This occurs overtly and obviously; and there is nothing wrong with that.
The second form is more covert. It is the denial of bad news; "see no evil, hear no evil, speak no evil". This form of confidence gaming allows for plausible deniability for market participants in the event something goes wrong.
This is what occurred during the creation of the subprime debacle and was epitomized after that bubble popped. The leaders of the U.S. financial industry closed ranks around the idea that they could not have seen the crisis ahead of time. Thus, the crisis was not their fault because there was no model for falling home prices.
This was an absurd idea but it has gone unchallenged by regulators and the boards of directors of these financial institutions.
As for China, their debt situation has been obvious and growing. This is especially the case since the massive preemptive financial stimulus measures were taken by the Chinese government after the Lehman crisis. That was an attempt to prevent a negative impact on the Chinese domestic economy. Yet, few institutional organizations have been willing to acknowledge the issue publicly.
Fitch's downgrade of China's long-term currency rating in April and report on its debt situation in June was the most recent acknowledgement by an institution that can't simply be waived off by investors or other interested parties as an isolated bearish stance by an individual or smaller organization. The plausible deniability part of confidence gaming by way of willing obtuseness is now gone and interested parties must confront a more complex reality with respect to the situation facing China.
The principal issue facing China now is what is called the middle income trap.
As a country moves from developing to developed status, its domestic economy goes through three principal phases: infrastructure development, manufacturing and real estate development and finally, technology.
In the early phases the country attracts foreign investment with cheap labor and the countries economy is export driven. As the success increases, the country creates a middle class which also causes the labor advantage to go away -- giving rise to the trap.
China was already on this natural trajectory before Lehman Brothers failed. The Chinese government's monetary and fiscal stimulus would have been used to attract foreign investment in long-term capital intensive technology development in China. That could have afforded the country the opportunity to grow out of the middle income trap and to attain and to maintain developed economy status. That stimulus was used instead to prevent the country from collapsing economically in 2008/2009.
The majority, and perhaps all of that capital, has been consumed with no positive residual economic multiplier. Left behind was both the sovereign debt and private sector debt.
If the Chinese economy slows further from here, any more counter-cyclical monetary and fiscal stimulus will immediately cause price inflation. That will result in a slowdown of the economy, and soon thereafter a popping of the private sector shadow banking debt bubble. That will immediately cascade into a popping of the debt bubble being experienced by the state run banking system.
This will lead to debt deflation and real deflation as losses are absorbed. This is a part of the natural, necessary, unavoidable and imminent process to potential recovery.
The principal difference between the situation facing China today and that which the U.S. faced after Lehman failed is that the U.S. had the sovereign capacity to counteract the private sector economic contraction and capital losses with monetary and fiscal infusions.
China already used their financial capacity to do the same with their monetary and fiscal stimulus following the Lehman failure.
The real questions for investors to consider now are these: When China experiences its Lehman moment, how it will impact foreign investors in the country? And how it will impact the rest of the world's financial markets and economies?
I will address those issues in future columns.
