Satyajit Das: 2 Outcomes – “Managed Depression” or “The Mother of All Crashes”

Hat tip to Bill Bonner for drawing our attention last week to the latest thoughts from former banker and financial author Satyajit Das who anticipates “the mother of all crashes” in China.

There are only two likely outcomes in China, he said: stagnation or collapse.

We’ve featured Das in these pages previously where he noted back in 2012 that:

…”China’s growth is somewhat false based upon bridges to nowhere and the like funded by government spending which he is not sure can continue forever. This will likely have a major effect on Australia due to China being their major customer for iron ore and coking coal.  While New Zealand will not be immune to the ongoing global stagnation, he thought given our role as a primary producer of food (and people will still have to eat), we may be less affected.”

Source.

So far this has proven pretty accurate with Australia certainly feeling the pinch from China’s reduced commodity purchases, while to date the impact on NZ has been less although perhaps is starting to build now.

Anyway, we went hunting to see where Das had made this comment and to get his latest thoughts. We found it mentioned in an interview on Equitymaster.com:

“You seem to remain unconvinced about the world having come out of the aftermath of the financial crisis and you write that a risk of a sudden collapse is ever-present. Why do you say that?

There are three possible scenarios.

In the first, the strategies in place lead to a strong recovery. The US leads the way. Europe improves as the required internal transfers and rebalancing takes place with Germany accepting debt mutualisation to preserve the Euro. Abe-nomics revives the Japanese economy. China makes a successful transition from debt financed investment to consumption. A financial crisis in China from the real-estate bubble, stock price falls and massive industrial overcapacity is avoided. Other emerging economies stabilise and recover as overdue structural reforms are made. Growth and rising inflation reduce the debt burden. Monetary policy is normalised gradually. Higher tax revenues improve government finances. There is even strong international policy co-ordination, avoiding destructive economic wars between nations.

Oh that is clearly a lot to expect…

Such an outcome is unlikely. The fact that current policies have not led to a recovery after 6 years suggests that they are ineffective.

The second scenario is a managed depression, a Japan like prolonged stagnation.

Economic growth remains weak and volatile. Inflation remains low. Debt levels continue to remain high or rise. The problems become chronic requiring constant intervention in the form of fiscal stimulus and accommodative monetary policy, low rates and periodic QE programs to avoid deterioration.

Financial repression becomes a constant with nations transferring wealth from savers to borrowers to manage the economy. Competition for growth and markets drives beggar-thy-neighbour policies, resulting in slowdowns in trade and capital movements.

Authorities may be able to use policy instruments to maintain an uneasy equilibrium for a period of time. But it will prove unsustainable in the long run. Ultimately, a major correction will become unavoidable, as confidence in policy makers ability to control the situation diminishes.

And what is the final scenario?

The final scenario is the mother of all crashes. Financial system failures occur as a significant number of sovereigns, corporate and households are unable to service their debt. Defaults trigger problems in the banking system which leads to a major liquidity contraction, which in turn feeds back into real economic activity. Falls in employment, consumption and investment drive a severe contraction. The problems are global with developed and emerging markets affected.

The downturn is exacerbated by the limited capacity of policy makers to respond. Weakened public finances and policy options (QE and low rates) exhausted in fighting the last crisis limit the ability of governments to respond to a new crisis. Emerging markets are now unlikely to be a source of demand due to their problems. Geo-political stresses are higher than in 2007/ 2008.

Unsurprisingly, no one wants to believe that the stagnation or collapse are the only two likely options. Hubris, as humorist PJ O’Rourke noted is one of the great renewable resources.”

From what we’ve read and seen of Das he is not one for hyperbole and to overhype things.

You can see an interview with him on New Zealand TV a few years ago here for some of his straight laced talk.

https://goldsurvivalguide.co.nz/writer-satyajit-das-on-how-new-zealand-will-fare-in-the-crisis/

 

Das Is Not The Only One Sounding Warnings

There are certainly a few pieces of news present at the moment to lend some weight to his assertions on China and the global financial system.

For example:

Chinese Reserves Dwindle and Why It Matters to You

The People’s Bank of China announced foreign exchange reserves dropped by another $100 billion in January. One expert explains why that could have devastating impacts on world markets.

“When foreign exchange reserves reach $2.8 trillion—which should only take a few more months at this rate—foreign exchange reserves will fall below the IMF’s recommended lower bound,” he said.

That is likely to trigger a “tidal wave of speculative selling,” which in turn will force the People’s Bank of China to allow the yuan to freely float within six months.

The yuan currently moves within a trading band set by the People’s Bank of China that the central bank can change at will.

“We estimate that if capital outflows maintain their current pace, the PBoC would be unable to defend the yuan for more than two to three quarters,” Wei Yao, Société Générale’s China economist, said in a report published earlier this month.

“China’s reserves have already fallen by $663 billion from mid-2014, and a further decline of this scale would start to severely impair the Chinese authorities’ ability to control the currency and mitigate future balance of payments,” she said.”

Source.

Kyle Bass is Also Concerned

We also have Kyle Bass, founder of hedge fund Hayman Capital Management sounding the alarm on China’s approach to managing its yuan exchange rate.

He recently  explained in depth on why he is shorting the yuan and the problem of escalating bad loans in China’s banking sector.

“This isn’t an aberration. This isn’t a speed bump. This is China’s excess — let’s call it misallocation of capital — coming home to roost,” he said. “You can’t grow your banking system 1,000 percent in 10 years and not have a loss cycle. And your currency won’t stay strong when you go to rectify that balance.”

See: ‘Big Short’ Guy Says China’s Banking System Is Near Implosion

Then finally we read a very interesting interview with Neil Howe (Author of the excellent book The Fourth Turning: An American Prophecy – What the Cycles of History Tell Us About America’s Next Rendezvous with Destiny), where he had his prognostications for 2016. This included quite a few on China:

“There are many reasons why China is now in trouble. Its industrial and real estate sectors racked up vast amounts of debt over the past decade, leading to excess production and capacity that is hard to unwind. Its overvalued currency is squeezing its export businesses, but any deliberate attempt to devalue would be like disarming a bomb, incurring the risk of sudden capital flight. Meanwhile, just as rural areas are running dry on new young adults to send to the cities, China is undergoing rapid demographic aging. Just this year and next, its working-age population has stopped growing and has now started a gradual decline. Basically, China has outgrown one growth paradigm and hasn’t yet figured out how to move to another.

So much for the causes of China’s woes. Let’s look at the effects. Most importantly, China’s slowdown shrinks an important source of rising demand that has helped keep global economies running over the past decade. Europe, for example, exports furs, fashions, and sport cars to feed China’s insatiable demand for brand-name luxuries. That is taking a hit. The U.S. and South Korea export films and smartphones to feed China’s mania for media and cool IT. That is also taking a hit.

The collapse of China’s infrastructure boom is a significant driver of falling global energy demand and a huge driver of falling global commodities demand. In 2014, incredibly, China constituted roughly half of the global demand for most major metals, from iron, copper, and nickel to all those once-treasured “rare earth metals” whose prices have since tanked.

China has been an economic juggernaut over the past quarter century. It has lifted more people out of utter destitution into at least modest affluence than any nation in history. But now its boom is coming to an end, after producing “ghost cities” without residents and “ghost bullet trains” without riders. As China changes its course, so must much of the rest of the world.”

In discussing why today is far worse than the lead up to the 1997 Asian financial crisis:

“In 1997, China was an inert bystander, with few financial ties to the rest of the world. Today, China is a slowly collapsing supernova, with such massive external trade and financial activity that even a slight change in its rate of decline will have large repercussions both regionally and globally. Without a doubt, China is the single biggest reason why what goes down for emerging markets in 2016 could be worse than in 1997.

What are their options?

Their first (and worst) option would be to stay the current course, losing reserves and credibility at a growing rate while failing to stop the currency decline. Before the year is out, they will have to enact a major devaluation anyway and do it from a position of weakness. Their second option would be a resolute defense of the CNY near its current level with much stricter capital controls and jacked-up interest rates. But capital will still seep out—and to prevent higher interest rates from killing the economy, they would have to switch entirely to fiscal stimulus. I just think it’s too late for this. Their third option would be to bite the bullet up front and enact a large devaluation (40% or more) that the PBOC is certain it could defend and then accompany that by further relaxing of capital controls. It is the best option, but since it requires boldness and political courage it is probably not the one Beijing will choose.

And finally he comments on which countries are getting hit hardest?

NH: Here’s how to think of it: If your country is dependent on exporting oil or commodities, or if you are close to China (which presumably means you trade a lot with China), it is likely you are feeling pain. Sadly, this rule of thumb covers the great majority of the developing economies.

The energy price collapse has obviously slashed income to most of the Middle East and to Russia and its Central Asian CIS allies. The energy and commodity declines together are dragging down nearly every nation in sub-Saharan Africa, many of which export little other than oil, gems, precious metals, and base metal ores. Ironically, most of the vast mining operations in Angola, Zambia, and the Congo were originally funded by China. The price declines are also a hardship for Latin America, a region already reeling from a catastrophic failure of political leadership (in Venezuela, Brazil, and Argentina). The IMF estimates the Latin American GDP, as a whole, actually shrank last year.

Among the regional Asian economies suffering from falling trade with China, let me mention Indonesia, Malaysia, and Mongolia. There are even some regional high-income economies who are struggling to adjust: Taiwan, Singapore, South Korea, and (to a lesser degree) Australia and New Zealand.”

Source.

 

Only 2 Options…

So much like Sanjadit Das back in 2012, Neil Howe also thinks New Zealand won’t escape China’s troubles unscathed. Albeit we may come off better than many in the developing world.

But bear in mind that in this latest interview, Das is speaking about what the entire planet should expect. And a reminder that his two likely options are not very pretty:

A managed depression such as a Japan like prolonged stagnation, or the mother of all crashes.

Perhaps the large rise in gold (and silver) since the start of 2016 is an advance warning of this? Possibly driven by more crazy  central banks moving towards the insanity of negative interest rates?

However given how fast this rise has occurred there is a very good chance we will see a decent sized pullback from here. Prices may retrace 50% of more of the run up since the start of 2016.

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