China in cri­sis? An­other credit crunch is more likely

The Pak Banker - - OPINION - Wil­liam Lit­tle­wood

BAD, yes. But get­ting worse? Re­cent move­ments in stock mar­kets have been dom­i­nated by pre­cip­i­tous falls in China. China bears pre­dict that the cur­rent is­sues will deepen, turn­ing into trou­bles sim­i­lar to those that caused the fi­nan­cial cri­sis of 2008-09. I do not think this will be the case. In the past 20-odd years there have been three pe­ri­ods of bub­ble-like con­di­tions glob­ally: the tech­nol­ogy boom of the late 1990s, the credit binge in the mid-2000s and a bub­ble in com­modi­ties in the last decade. The first boom led to over­build­ing of ca­ble in­fra­struc­ture and per­ma­nent loss of cap­i­tal in the tech­nol­ogy sec­tor.

The se­cond boom led to over-bor­row­ing and the de­fault of sev­eral banks. The com­mod­ity bub­ble burst­ing is likely to lead to the de­fault of com­mod­ity-pro­duc­ing busi­nesses - and per­haps of some Chi­nese banks too - and to a glut of ex­cess pro­duc­tive ca­pac­ity. If the pri­mary re­sult is cheap com­modi­ties, then many con­sumers and de­vel­op­ing na­tions (such as In­dia) will ben­e­fit. Se­condly, while the fragility of the fi­nan­cial sys­tem was ex­posed in 2008-09, I do not ex­pect a re­run: es­pe­cially in Bri­tain and Amer­ica, banks are much stronger and have learnt many lessons.

Crises rarely re­peat them­selves ex­actly, but in­vestors nat­u­rally re­call the last cri­sis and re-pre­dict it, even if they al­most cer­tainly didn't see it com­ing last time. There are too many vo­cal bears out there now com­pared with 2008. For ex­am­ple, RBS re­cently urged in­vestors to "sell ev­ery­thing". I can­not re­call any such warn­ing in 2007 or 2008. Time to 'sell ev­ery­thing'? No, this is when 'hold ev­ery­thing' works My greater con­cern is that while look­ing for trou­bles in the East, in­vestors are ne­glect­ing un­solved prob­lems in the west. In the con­text of poor growth, the high lev­els of sov­er­eign debt in many de­vel­oped na­tions are un­sus­tain­able. This has been masked tem­po­rar­ily by the ac­tions of cen­tral bankers, who have sup­pressed in­ter­est rates to his­tor­i­cal lows and in turn made bor­row­ing costs ap­pear man­age­able.

Italy, for ex­am­ple, has debts equal to 102pc of its eco­nomic out­put, com­pared with 87pc be­fore the cri­sis of 2008 09. It cur­rently costs the Ital­ian govern­ment 1.5pc to bor­row money for 10 years. This com­pares with an av­er­age of 4.5pc in the 2000s. This im­plies that if govern­ment bor­row­ing costs were to re­turn to their pre­vi­ous av­er­age, the state would need to run a bud­get sur­plus of roughly 4.5pc just to cover in­ter­est costs and keep debt lev­els con­stant. This seems nigh-im­pos­si­ble to me, given that the coun­try has con­sis­tently run a bud­get deficit ev­ery year for the past 20 years.

Th­ese is­sues ap­ply to a num­ber of coun­tries. They seem in­sur­mount­able as the re­sult of poor de­mo­graph­ics and of the inherent na­ture of democ­ra­cies: politi­cians are en­cour­aged to in­crease debt to pay for free health­care and gen­er­ous state pen­sions. As Jean-Claude Junker, now the pres­i­dent of the Euro­pean Com­mis­sion, put it when he was prime min­is­ter of Lux­em­bourg: "We all know what we have to do. We just don't know how to get re­elected af­ter we've done it." Up 300pc in five years: ' This in­vest­ment story is still in­tact'

And yet the yields on the bonds of de­vel­oped coun­tries, which move in in­verse re­la­tion­ship to the prices of those bonds, are at record lows and near­ing zero or even neg­a­tive in some cases. This is clearly at odds with eco­nomic re­al­ity but also with com­mon sense. An in­ter­est rate is fun­da­men­tally an ex­pres­sion of hu­man "time pref­er­ence".Zero in­ter­est rates im­ply that hu­mans don't care whether they re­ceive money to­day or in 10 years' time. Not only is that il­log­i­cal, but even more so is the con­cept of neg­a­tive in­ter­est rates.

Take a Ger­man five-year bond yield­ing - 0.23pc. This im­plies that the Ger­man govern­ment is paid to is­sue debt. It also im­plies that in­vestors are will­ing to pay 100p to re­ceive 99p in five years' time. This makes no sense to me. An of­ten cited rea­son to hold govern­ment bonds is an im­pend­ing threat of de­fla­tion ("ex­ported from China"). How­ever, given the enor­mous bur­dens of debt in many Western na­tions, this makes lit­tle sense to me.

How to play the fi­nan­cial tur­moil: Tele­graph in­vest­ing ideas I think about it this way: is a mort­gage less or more valu­able on a prop­erty whose price has fallen? In­fla­tion is a friend to a bor­rower and de­fla­tion is an en­emy. For all of th­ese rea­sons, in our fund the big­gest po­si­tion (99pc of its net as­set value) is a "short" on the govern­ment bonds of cer­tain de­vel­oped coun­tries. That is, th­ese po­si­tions will pro­vide a pos­i­tive re­turn if the prices of bonds fall, and their yields rise. One might make the ar­gu­ment that if bonds are over­val­ued, shares are too. I con­tinue to have a cau­tiously op­ti­mistic at­ti­tude to­wards shares and have added to our hold­ings in re­cent mar­ket falls.

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