Worth Wray on the Single Most Dangerous Catalyst for a Global Financial Crisis
If you want to know what's spooking the market and why some big names are quite concerned about global financial stability, Worth Wray, Chief Economist at Evergreen Gavekal, recently laid out the entire situation in a very timely and an-depth interview with Financial Sense. As he explains, the renminbi is perhaps the single most important catalyst for sparking a global financial crisis for reasons cited below. Here are some of his comments (make sure to read to the end):
Worth: "It's no secret that China is slowing under a massive debt burden. After the financial crisis of 2008, China went on one of the biggest debt binges in modern history. There are very few parallels and any close examples have ended in hard landings. These kinds of rapid debt growth periods never end well and lead to broad based misallocation; it leads to a lot of bad assets and non-performing loans in the banking sector (even if they're hidden in China right now). It's a problem that's draining liquidity from the banks; it's sapping growth potential. And so China's economy is naturally slowing. Now a slowdown is something that you'd expect anyway in China because you're seeing that economy get much bigger and you're seeing real GDP per capita grow—you always see economies slowing like that as they develop. But this is a different matter. This is largely debt-induced and China has exhausted the growth model that's driven it for so long which is largely reliant upon credit, upon investment, and that can't go on any longer. The trouble here is that making the transition to a new economic model driven by consumption and services and technology, it sounds fantastic but it's going to require a cleaning out of the banking system, a cleaning out of bad debt—t's going to require a tremendous amount of upheaval in these old-economy sectors like infrastructure, construction, real-estate, mining and I'm afraid China is past the point of no return. I don't think it can pursue that rebalancing plan without Beijing losing an extraordinary amount of control, probably without a hard landing."
"One of the last things we talked about in our last interview was the stock market bubble that Beijing blew. Regardless of slowing growth and really just ugly, disappointing economic fundamentals the stock market rose to heights that we've rarely seen—comparable to the tech bubble—with median PEs at astronomical levels and a lot of people thought that was a bull market and thought that it would continue, thought that the economy would catch up, that it was reflecting something positive. What we talked about was that the stock market bubble was really a plan of Beijing's—it was a bit hair-brained—but to blow a bubble, attract foreign investors and then that would give their troubled investors with too much debt an option away to deleverage, to reduce their debt loads by issuing equity. What we know is that when MSCI declined to come into the country and the stock market started to crash, Beijing responded very poorly...and showed it's true colors that China is not actually a market—it's an authoritarian system where the market works as long as Beijing wants it to. If the market runs contrary to Beijing's interests, Beijing will step in the way. And they failed massively. This really eroded confidence in the system and...they lost control."
"What really matters right now is the renminbi...but I'm concerned that Beijing is running out of options, they won't be able to defend the renminbi for very much longer and they may have to let it float. That may end up leading to a better outcome for China long-term...but it's a very nasty development for global growth, for global economic stability and threatens unleashing huge deflation in the developed world, a very strong dollar, and I think maybe the next global financial crisis."
"What I'm concerned about when it comes to the global financial system is it's really about the interaction of the dollar and the renminbi. You have about 10 trillion dollars in dollar-based debt or credit extended to the world...the stronger the dollar gets, the weaker the commodity prices get, the more pressure gets put on a whole range of emerging market economies. If you get a stronger dollar, which I think you are already in a position to get if we get more European Central Bank competitive easing, more Bank of Japan competitive easing, then the dollar can go up easily another 10%, maybe a little more. But if the renminbi goes, if that happens, then I think you're setting up for a very big dollar rally so the pressure on commodities, the pressure on dollar-debts, that gets amplified at the same time that there's a big shock to global manufacturing competitiveness and there's a wave of deflation that comes over the world."
"If you look at emerging markets today, they make up almost 50% of global economic growth. That is roughly double where they were in the late 1990s with the 1997 Asian Financial Crisis, 1998 Russian Crisis. We also have a far more levered global financial system and a far more interconnected global financial system....so the financial ramifications are difficult to see. Looking back it's easy to understand why financial crises happen and exactly why they play out the way they do. Looking forward all we can do is rest on the lessons of history and say we've been in similar situations before that produced very dangerous financial shocks with a less interconnected, less leveraged financial system where the shocks came out of countries that were seemingly insignificant like Thailand—they didn't have meaningful trade and financial linkages and yet they unleashed hell. So I think we have to look at this situation and be very cautious. We could easily be talking about a global recession...but it could easily go into a financial crisis as well and the renminbi is the single most dangerous catalyst."