Was Fed fire alarm warning of danger in Chinese economy?
ON May 22, US Federal Reserve chairman Ben Bernanke triggered one of the biggest financial panics since 2008 by raising the possibility of reducing its monetary stimulus. He also admitting that he had no idea when to start this process.
Bernanke spent the subsequent six weeks trying to clear up the mess he had created by explaining the precise timing and conditions under which “tapering” might or might not take place.
In the process, he created even greater confusion and financial volatility.
His comments acted as a financial alarm bell, drawing attention to risks in the world economy that were forgotten or ignored.
When we hear a fire alarm, we naturally ask ourselves three questions: Is it a false alarm? Is it a fire drill? Or is it a real fire — and if so, where? Similar questions may shed some light on the tapering scare.
For the US stock market, Bernanke’s May comments were clearly a false alarm, because the Fed was nowhere near a decision to tighten monetary policy. It is not surprising, therefore, that US equity prices have rebounded to their preBernanke record highs. But looking beyond the US stock market, tapering speculation seems more like a fire drill than a false alarm.
Long-term interest rates have risen sharply as the world has been reminded that central banks will not continue buying government bonds forever. Following this reminder, investors who tie up their money for 10 years or more in long-term government bonds are now demanding a premium of 2.5 to three percentage points above Fed funds.
Such steepening of the term premium is a perfectly natural and healthy development as economic conditions normalise, as they seem to be doing in the US. But the rise in long-term US interest rates is a problem if it happens too suddenly, which is why Bernanke may have done the US a favour by testing the vulnerability of the housing market and Wall Street to higher rates.
Unfortunately, the fire drill analogy looks too complacent once we shift attention from the US and Europe to the emerging markets, where currencies, equities and bonds have all been collapsing, along with consumer and business confidence. Perhaps the financial alarms of the past two months really did warn of danger — not in the US or Europe, but in emerging markets and specifically in China.
The biggest worry is that the Chinese authorities, in trying to gain control of their unregulated shadow banking system, will squeeze too hard. The result could be either a Lehman-style financial implosion or a disastrous credit crunch among the private sector, consumer-oriented companies on which China must rely for its next phase of growth.
China’s private companies are supposed to take up the economic slack left by the decline of exports and heavy industry. But these companies rely largely on the shadow banking system because they tend to be denied credit by the big government-dominated banks. Thus China’s efforts to control its informal banking system could stifle the very businesses on which the economy now depends for future growth.
The government may try to force state-owned banks to redirect their lending from infrastructure, property and exports to the private sector. But there is an obvious paradox in imposing tighter central planning on the financial system to encourage growth of a private market economy. Such paradoxes suggest the alarming possibility that China’s model of communist-controlled capitalism may be approaching its limits.
The risk that something may go wrong with the Chinese economic model as it tries to navigate the transition to consumer-led growth dominated by the private sector is the greatest risk facing the world economy. This is a risk with low probability, but potentially huge impact. By comparison, whatever the Fed may or may not decide about US monetary policy is a sideshow. Judging by recent market behaviour, investors are coming to this conclusion.