Money created from nothing and tossed from central bank helicopters into the financial markets has become the norm. The sky is raining dollars and euros and yen. The thunderstorm has continued unabated since 2008, and nine years later there’s no end in sight, despite chatter from the central bankers on their desire to pull back. They can’t.
For generations, the Federal Reserve and the other global central banks could only control the short end of the bond markets. They had some, but not much, effect on the long end and less influence on the equity markets. Well, that world no longer exists. I doubt that it will exist again during our lifetimes. This, as television variety show host Ed Sullivan used to say, is the “really big show” that most investors are ignoring because the central banks do everything in their power to try to get them to ignore it.
The Fed’s balance sheet has been ramped up to $4.48 trillion. This is not from the creation of new money, but from the interest earned on the money they have already created. Therefore, if one thinks it through, it is the creation of money squared. The Fed is still making new money, just in a different fashion. How convenient.
The Swiss National Bank, the Bank of Japan and the European Central Bank are still performing their magic tricks. Money for nothing, checks for free, buying corporates, buying equities, buying derivatives and as the rock group Dire Straits aptly put it, “Now look at them yo-yos, that’s the way you do it.”
So, in the U.S., Switzerland, the European Union and Japan we have a bunch of unelected officials sitting in the “counting houses” making money and tossing it about as they see fit. They make every argument imaginable about keeping their independence. Who wouldn’t? They are controlling the world. Yes, I mean exactly and precisely that, “they are controlling the world.” As Mayer Amschel Rothschild, the founder of the Rothschild banking dynasty, is credited with saying, “Give me control of a nation’s money and I care not who makes its laws.”
That’s why the Fed’s calls to return to normalcy are nothing but blather. It is one more attempt at distraction while more money is generated from the flicks of a wrist on some central bank’s keyboard.
In practical terms, what does it mean? It means the equity markets are not going down, in any significant manner, at any time in the foreseeable future. It’s the flow of money, not earnings, that is driving the bus.
It also means bond yields are not going up in any significant manner in the foreseeable future. We are again at the 2.32 percent line in the sand for the benchmark 10-year Treasury note. It could bounce this way or that way in the short term, but a 3 percent yield is not happening any day soon.
Yield spreads as measured by the Bloomberg Barclays Investment Grade Corporate Bond Index are the tightest of the year at 103 basis, which is also the tightest since measuring 102 basis points in September 2014.
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China Did Stimulus the Wrong Way
When the Great Recession hit, China didn’t hesitate to open up the fiscal taps. But the fast-developing country also embraced another form of stimulus that was a bit different from what John Maynard Keynes had recommended — it encouraged its banks to start lending a lot more. They lent money to corporations, local governments and a variety of private actors. Much of this lending was financed by the issuance of so-called wealth management products (WMPs) — basically, high-interest loans made by Chinese households to a variety of bank-affiliated lenders.
A new paper by economists Viral Acharya, Jun Qian, and Zhishu Yang provides a lot of detail about what happened. In China, there are four really big banks owned by the central government — Agricultural Bank of China, Bank of China, China Construction Bank and Industrial and Commercial Bank of China. When the aftershocks of the Great Recession threatened the economy in 2009-10, the Chinese government told its banks to lend more money, and they did so — the increase in lending from the Big Four banks during those two years totaled about 7 trillion RMB, or $1 trillion.
But that put China’s smaller banks in a bind. In order to maintain regulatory loan-to-deposit ratios, the big banks had to take more deposits from Chinese households, and they did this by offering better deposit rates and various other incentives. This created stiffer competition for smaller banks, forcing them to find some other source of financing. They couldn’t just offer higher deposit rates, since deposit rates are capped by the government. Their answer was WMPs, which they issued indirectly by creating a large system of so-called shadow banks, or lenders that operate outside of the regulated financial regime. As Acharya et al. document, the more local competition there was from the Big Four banks, the more WMPs the smaller banks issued.
China watchers, including my Bloomberg View colleague Chris Balding, have long been worried about the risks posed by the WMPs and the shadow banking system that supports them. As the U.S. experience in 2008 and many other episodes around the world have shown, large amounts of high-interest loans created by complex networks of shadowy, unregulated lenders can be the tinder that sparks a financial crisis.
Acharya, et al. give some new evidence to justify this worry. They show that when WMPs mature, interbank lending rates go up — a scary indicator for anyone who remembers the American interbank freeze-up in 2008. Higher interbank lending rates in turn cause Chinese bank stocks to fall, with banks that issued more WMPs falling by more. WMPs are thus creating risks for the entire Chinese financial system.
But that’s not the only way China’s odd, unique form of stimulus created new risks. There’s also the issue of who received those loans. Another new paper, by economists Lin Cong and Jacopo Ponticelli, shows that the stimulus funneled money to low-productivity state-owned companies.
From 2000 to 2008, everything seemed to be going right in Chinese industry. Lending kept shifting from less productive companies to more productive ones, and from state-owned enterprises to the private sector. That’s a sign of a healthy economy. After 2008, though, that positive trend went into reverse. Cong and Ponticelli document how state-owned companies started taking a larger share of lending, and that businesses with lower rates of return on capital before 2008 borrowed more.
Money flowing to less productive companies is always bad news. But when combined with the increase in high-interest loans and interbank lending risk documented by Acharya et al., it’s a recipe for a financial crisis. Low-productivity borrowers are less likely to repay their loans. So the quality of loans has gone down at precisely the same moment that systemic risk has risen.
Even more worrying, the lending binge didn’t stop after the Great Recession ended. A figure from Cong and Ponticelli’s paper shows how the money has continued to flow, supported by more shadow banking and corporate bond issuance:
This seemingly permanent increase in lending since 2008 has coincided with a reduction in real economic growth:
More borrowing, lower-productivity borrowers, slowing growth, and greater systemic risk are all consistent with the story that China’s economy has become too dependent on cheap, plentiful often wasteful financing.
Naturally, the Chinese government is aware of the risks, and is taking some steps to reduce them. For example, the authorities are pushing lenders to lower the rates of return they offer on WMPs, which promises to reduce risky lending. But these measures may be too little, too late. A huge stock of high-interest debt has been accumulated by low-productivity borrowers. It will take years to unwind. Those years will probably bring slower growth for China, even as the risk of a general Chinese financial crisis continues to be elevated.
There’s a lesson here for future policy makers. When recession threatens, forcing banks to lend money cheaply is a very dangerous form of fiscal stimulus. Countries would be well-advised to stick with Keynes’ original idea, and simply have the government spend a bunch of money on infrastructure when the economy falters.
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