Welcome to Finance and Fury

  1. This episode, look at where the next financial crisis may come from – Will it be from the USA or from China? This is a question I was thinking about the other day – as there is a lot of talk about the Chinese economic being built on a house of cards and at risk of collapse – but if this does collapse, will it lead to a world-wide economic recession? Or, will the USA beat China to the chase and trigger the next collapse?
  2. So, in this episode – we will look at the likely nature of the next financial collapse and whether this will be triggered by economic issues in the USA or China

Looking back in history – the idea of a global financial crisis is relatively new in the scheme of things

  1. it has and can only occurred in times when economies are interconnected in terms of trade, or financial reliance – in the modern era – this is coined as globalisation – but the trigger has tended to come from the economically dominant country in this economic system – i.e. the most connected nation that a global economy is reliant on
    1. Therefore – it is no surprise that over the last 100 years, the United States has become the primary source of economic collapses that have spread to throughout the rest of the world
    2. In reality – over the last 200 years, the USA averaged a financial panic every twenty years – which over this timer period puts it in competition with the UK for the most occurrences of economic disaster of any country on the planet –
    3. What is different is the size and scale on these panics’ effects on the rest of the world – The USA has only really been an economic powerhouse from the post WW1 Era – hence previous panics, such as the Railroad panic of 1873 has far less effect on the global economy and their financial markets when compared to an event like the GFC, or even share market collapse that preceded the great depression of the 1930s
  2. There is an emerging trend within an interconnected global economy – when the major economic powers catch a cold, the rest of the world starts to sneeze – Which brings up China – which over the last few decades has emerged to be the second largest economy behind the USA – where both countries are heavily reliant on one another – USA relies on China for consumption and debt funding, and China on the USA on net exports and reinvesting those funds in treasury notes through foreign exchange – but this relationship can be rocky
    1. Almost like business partners who have grown to hate one another over the years – but both parties know that without the other their business would fail

This brings us back to today’s topic – the next financial collapse

  1. Regardless of where it comes from – The form of the next financial crisis will very likely be initiated from the financial system – and in the from excess levels of leverage within a fragile system, created through speculation
    1. Technology and innovation have adapted in regards to leverage as well as investors access to leverage –
      1. When looking through all financial crisis – whist the triggering cause has differed – the common characteristic has been that the economy become fragile due to excess levels of leverage – i.e. borrowed money creates additional asset bubbles and exacerbates downturns
    2. Looking back in history – the crash of 1929, which triggered the great depression, came from an overleveraged market that was built up through the introduction of margin loans in the previous decades, as they became popular around the 1890s – then the requirements of these loans, that have the shares as collateral, became even more loose in the early 1900s – leading to the build-up and eventual collapse of the share market –
    3. Skipping forwards to the 2000s – systems of leverage had evolved dramatically – with CDOs, as well as synthetic derivatives which first came into use in the 1980s – These instruments combined with speculation lead to the inevitable collapse that occurred in the GFC
    4. In the modern era we are now looking at highly leveraged crypto positions using derivatives, as well as the age-old overleveraged markets both in property and shares –
    5. So – regardless of the technology of the mechanism that the money flows into – one common characteristic stays the same is that financial corrections comes from over-leveraged positions that occurred due to speculation – in other words – the higher the level of capital which can be introduced into an economic system under speculation, the greater the risks are to that system
  2. This brings us to today – where the fact that leverage has been allowed to increase at ever increasing pace due to low interest rate policies globally means that at some point – the mount of excess leverage that exists within the economy increases beyond the productive level of the economy – hence it becomes speculation – therefore, at some level it must come unstuck
    1. Speculation through leverage (i.e. debt) – used to have an opportunity cost – the concept of an economy having a near-zero interest rate policy like we currently have in place was considered to be extreme monetary policy and only to be utilised for emergencies – but in a country like the US, this has been in place since 2009 – rates did rise from 2016 to 2020 to 2.5% but then came back to 0.25% and will likely be there for a number of years – like is the case in most economies – Aus is at 0.1%
    2. The economy is a complex system – it is almost impossible to understand fully – when one input it introduced, there is no way to tell what the economic consequences will be long term beyond the first order of consequences
    3. Whilst not a perfect analogy – think of the economy as the human body – a very complex system with many different factors as inputs – some people are allergic to peanuts – whilst others aren’t
    4. low interest rates act as a pain killer to the economy like morphine to the human body – when someone goes into an emergency and break their leg – they will likely get morphine to help relieve the pain – and understandably so – but normally after the initial pain has been endured and the bone is set – the morphine is reduced and eventually removed – because what happens otherwise? It is an opioid – and highly addictive – if you stay on too long you eventually get hooked and this can lead to a dark road –
      1. Your life can fall apart and at some point – you either die from an overdose due to needing to increase the load of the dose – or have to detox – which is also not a fun process – this is where much of the world economy is currently at – we will need to detox from low interest rates at some point – or see an economic death – in the form of a monetary reset
    5. Regardless of this fact – Monetary officials are still working off the theory is that low interest rates allow individuals and businesses to borrow money and pay less interest – which should encourage further spending throughout the economy and support the multiplier effect and economic growth
      1. but this theory neglects the Cantillon effect – where the money is first received – receives the highest level of benefit – and as the increase of borrowing and level of debt is directly injected into the property market, as well as injecting liquidity into the share market – these are two of the primary areas which have seen pricing move into overvalued territories – i.e. they have seen rises dramatically in price in a short amount of time that isn’t proportionate to its value
      2. This also makes sense from a risk perspective – when interest rates are low – money becomes cheap and investors can afford to invest more money into higher-risk asset classes – the opportunity cost of losing money becomes less – i.e. if you can borrow for 2% then the risks of investing in the share market are lower than if you had to borrow funds at 7% p.a. – where you need a higher hurdle rate to compensate your borrowings – this also leads to a spike to asset prices
        1. In most economies – the signs of a boom are everywhere – House prices are soaring, demand for consumer goods is high, financial markets are at record levels, commodity prices are booming with iron ore and copper is hitting fresh records
      3. This is where asset bubbles can then lead to recessions when the flow of new money stops or slows significantly and prices drop, causing some to lose large sums of money – this is due to the leveraged nature of speculation – the amount of money can artificially be increased by borrowings – so if borrowing are recalled, the nominal rate of money is reduced at a greater rate than otherwise possible


What would trigger such a crash?

  1. To be honest – I have no idea – it could come from any number of reasons – and likely will not come from one induvial cause, but instead be a cascade of events to lead to a complete market collapse –
  2. This being said – markets are essentially deep into the late stages of a bubble and is over leveraged – but as long as leverage can continue to grow, there is no reason for this gain to drop – but if it doesn’t, there are many sectors that are susceptible to deleveraging – through interest rate hikes or call backs from financial institutions
    1. Many businesses have had to borrow more money to finance their revenue losses through the lockdowns
    2. Property markets are up – with people borrowing more and more, increasing the overall household debt levels
    3. Share market is up – combined leverage rate of margin loans are at elevated levels
    4. Governments are also highly leveraged – with government deficits increasing at accelerated paces
  3. At some point, something will spook the market – whether it be some more inflation, the threat of an interest rate increase resulting in major market defaults – and central banks not willing to start up the printing presses to bail out these companies – your guess is as honestly as good as mine

But where will it come from? USA or China – which are both rapidly growing in unproductive debts – so let’s look at each one separately

  1. Risks from China – this is the most populous and second largest economy in the world – it also has the largest rates of economic growth in history – transitioning from a improvised nation to an economic powerhouse within a few decades – pulling hundreds of millions out of poverty – which is fantastic – and speaks volumes of the power of a free market compared to centrally planned economies (China started the transition in 1978 out of) – where individuals were empowered with the ability to incentivised to keep what they produce – in terms of labour and being paid a wage, or even agriculturally – which is what sparked Chinas transition of population starvation from the 1980s
    1. But this meteoric rise is not without its issues – many of these are overlooked – because when things are going well you tend to not pay attention to the underlying problems
    2. The number one issue to the Chinese economy is unproductive debts – China’s debt has grown dramatically over the past decade and is one of the biggest economic challenges confronting the ruling Chinese Communist Party – which actually has just turned 100 this year
    3. The CCP has identified the ballooning debt pile as a potential threat to its economic stability, and in recent years tried to reduce the economy’s reliance on debt for growth – as well as rebalancing levels of public debt within private debts
    4. China’s build-up of debt to fuel economic growth has raised fears of an eventual collapse – So, what factors would precipitate such a collapse? And if one were to occur, how would it affect the rest of the world? How can Chinese policymakers guard against financial crisis? 
    5. Looking at the figures – and a big disclaimer – all of these figures are generally based around what China reports – so there is no way to tell that these are accurate – not only exclusive to China, as it is hard to trust any Government Data
      1. China does have high levels of debt – but not the same ratios as many western nations –
      2. China’s overall debt was 270.1 per cent of gross domestic product – increasing by 10 times over the past 15 years – which is a massive increase
  • However – unlike many other nations – this level of debt is in the non-financial corporation sector – compared to counties like Aus where it is in household debt
  1. Around 70% of their domestic debt is in non-financial corporations – only 10% is in household debt
  1. Almost all of this lending is official, coming from the government and state-controlled companies. Over the years, China has been lending to emerging economies such as those in Africa.
    1. On top of this debt – their Loans to low-income countries – According to a report by the Institute of International Finance in January 2021, China’s outstanding debt claims on the rest of the world increased from about US$1.6 trillion in 2006 to more than US$5.6 trillion as of mid-2020, making China one of the biggest creditors to low-income countries.
  2. Now – China is starting to see the pressures of an over-leveraged nation – up until now they have seen strong consistent growth – One major factor that is keeping their economy from collapsing is FDI -which is increasing year or year still
    1. Whilst there is real growth – people will see their quality-of-life increase – but everything good has to come to an end –
    2. Due to urbanisation of population – major cities in China’s property markets are incredibly inflated when compared to disposable incomes
  • But this overleverage economy is susceptible to downturns in the leveraged markets
  1. Risks – Collapse from business debts – also, defaults from African nations
  2. But Chinas interest rate is around the 3.85% – far from a ZIRP – so they do have the capacity to lower interest rates further
  1. Risks from USA – comes from the level of their overall debts and their financial system complexity
    1. There is little new here – the real economic output of the USA is now becoming stagnant again – infrastructure and manufacturing, as well as gas jobs are now on hold, if not gone completely, due to politics
    2. But the USA does have one thing going for it – the Federal Reserve – if any market declines occur – the Fed is well positioned to step in and bail out any market declines
    3. But this saving grace is their economic destruction in the same sequence – one hand can give whilst the other hand can take everything away – the propping up of financial markets can occur for an indefinite period
    4. All whilst the real economy, i.e. real economic employment, can come crumbling down, amongst it all
    5. I think that America still has one or two more systemic crashes in it before China becomes another source – it all has to do with reliance and banking policies
    6. China to date has been a relatively segregated financial system – when looking at the interconnected markets of financial derivatives and speculative leverage, China surprisingly has low levels of connectivity – USA is still number 1 – therefore, there is a higher level of risk from their financial system – a small risk can snowball

Risks to Australia – the same risks as in the past – both China and USA have highly correlated economies to Australia

  1. The risk to Australia from China comes in the form of demands for our goods – which is our export market of many of our natural resources
  2. But regardless – when looking at historical crashes that have dropped out market – these have come from financial market crashes –

In summary – in my personal view – the next triggering event will likely come from the USA – the world is more reliant on the USA than China at the moment – I know that in Australia, our net exports are a different story, as we are likely more reliant on China as an economy – but we are talking financial markets here – where the ASX is more closely linked to the US markets than the Shanghai Composite or the Shenzhen Component Index

Thank you for listening to today’s episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

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