Tuesday, April 19, 2011

This Time Is Different

Two passages worth remembering, followed by its comparison to China.

From Carmen Reinhart & Kenneth Rogoff's "This Time Is Different : Eight Centuries of Financial Folly"

Banking Crises in Repressed Financial Systems
Our sample includes basically two kinds of banking crises. The first is common in poor developing countries in Africa and elsewhere, although it occasionally surfaces in richer emerging markets such as Argentina. These crises are really a form of domestic default that governments employ in countries where financial repression is a major form of taxation. Under financial repression, banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payments system, not simply currency. Governments force local residents to save in banks by giving them few, if any, other options. They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate; financial repression thus constitutes a form of taxation....

Governments frequently can and do make the financial repression tax even larger by maintaining interest rate caps while creating inflation. For example, this is precisely what India did in the early 1970's when it capped bank interest at 5 percent and engineered an increase in inflation of more than twenty percent...)
Inflation rate in China: 5.5%
Average rate on deposits: 1.4%
Average rate on Chinese bank assets: 3.7%

The Lessons of History

The lesson of history, then, is that even as institutions and policy makers improve, there will always be a temptation to stretch the limits. Just as an individual can go bankrupt no matter how rich she starts out, a financial system can collapse under the pressure of greed, politics, and profits no matter how well regulated it seems to be.
We have come full circle to the concept of financial fragility in economies with massive indebtedness. All too often, periods of heavy borrowings can take place in a bubble and last for a surprisingly long time. But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.
China's Fixed Asset Investment as a percent of GDP: 47 - 65% (depending on what figure you use)
That is a $3.5 trillion+ investment program.
According to a recent article, it now takes $4.3 of debt to create $1 of growth in Chinese GDP. The average for the US from 2001-2010 was about $4 to $1.

Buffett used to say, bubbles usually have their beginnings in something fundamental; public mania just takes the concept too far. China began its fabulous growth by becoming the world's exporter of choice. Yet gradually, an ever larger amount of GDP was composed of new fixed investment. And after the financial crisis, the Chinese government enforced a higher, unprecedented level of investment, taking its share of GDP from the mid 30's to where its at today.

Step back and think about that for a minute... through one of the biggest drops in demand ever... with Chinese wage pricing and currency levels rising... their level of new investment soared. It should be concerning.

As for commodities... Is this time really different?

Source: Macleans