by Tyler Durden
Back in December 2013 [13]we pointed out something that virtually nobody had noted or discussed: when it comes to “credit” creation, China’s $15 trillion in freshly-created bank loans since the financial crisis – ostensibly the global credit buffer that allowed China to not get dragged down by the western recession – dwarfed the credit contribution by DM central banks.
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This is how we simplified what was happening at the time:
In order to offset the lack of loan creation by commercial banks, the “Big 4” central banks – Fed, ECB, BOJ and BOE – have had no choice but the open the liquidity spigots to the max. This has resulted in a total developed world “Big 4” central bank balance of just under $10 trillion, of which the bulk of asset additions has taken place since the Lehman collapse.
How does this compare to what China has done? As can be seen on the chart below, in just the past 5 years alone, Chinese bank assets (and by implication liabilities) have grown by an astounding $15 trillion, bringing the total to over $24 trillion, as we showed yesterday. In other words, China has expanded its financial balance sheet by 50% more than the assets of all global central banks combined!
And that is how – in a global centrally-planned regime which is where everyone now is, DM or EM – your flood your economy with liquidity. Perhaps the Fed, ECB or BOJ should hire some PBOC consultants to show them how it’s really done.
This dramatic divergence in credit creation continued for about a year, then gradually Chinese new loans topped out primarily due to regulation slamming shut debt creation in the shadow banking space, [15] and since credit accumulation resulted in parallel build up in central bank reserves, the current period of debt creation going into reverse has led to not only China’s currency devaluation but what we first warned was Reverse QE [16], and has since picked up the more conventional moniker “Quantitative Tightening [17].”
But while China’s credit topping process was inevitable, a far more sinister development has emerged: as we showed earlier [18], while DM central banks – excluding the Fed for the time being – have continued to pump liquidity at full blast into the global, fungibly-connected, financial system, there has been virtually no impact on risk assets…
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… especially in the US where the S&P is now down not only relative to the end of QE3, but is down 5% Y/Y – the biggest annual drop since 2008.
This cross-flow dynamic is precisely what David Tepper was trying to explain to CNBC two weeks ago [20]when the famous hedge fund manager declared the “Tepper Top” and went quite bearish on the stock market.
This dynamic is also the topic of a must-read report by Citi’s Matt King titled quite simply: “Has the world reached its credit limit?” and which seeks to answer a just as important question: “Why EM weakness is having such a large impact”, a question which we hinted at 2 years ago, and which is now the dominant topic within the financial community, one which may explain why development market central bank liquidity “has suddenly stopped working.”
King’s explanation starts by showing, in practical terms, where the world currently stands in terms of the only two metrics that matter in a Keynesian universe: real growth, and credit creation.
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His summary: there has been plenty of credit, just not much growth.
So the next logical question is where has this credit been created. Our readers will know the answer: the marginal credit creator ever since the financial crisis were not the DM central banks – they were merely trying to offset private sector deleveraging and defaults; all the credit growth came from Emerging Markets in general, and China in particular.
[22]
So while we now know that EMs were the source of credit creation, why care? Why does it matter if credit was mostly being created in EMs vs DMs, and isn’t credit created anywhere essentially the same? The answer is a resounding no, as King further explains.
First, looking at credit creation in the post-crisis developed markets reveals something troubling: because credit creation takes places mostly in markets and is locked in central bank “outside” money which does not enter the broad monetary system, as opposed to bank credit creation in which banks issue loans thereby creating both new loans and deposits, i.e., money, the direct impect of DM central bank liquidity injections has been to created asset-price inflation. However, the offset has been far lower broad money creation – as there is far less credit demand in the first place – leading to no incremental investment, and far lower economic multipliers.
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Alternatively, it should come as no surprise that credit creation in EMs is the opposite: here money creation took place in the conventional loan-deposit bank-intermediated pathway, with a side effect being the accumulation of foreign reserves boosting the monetary base. Most importantly, new money created in EMs, i.e., China led to new investment, even if that investment ultimately was massively mis-allocted toward ghost cities and unprecedented commodity accumulation. It also led to what many realize is the world’s most dangerous credit bubble as it is held almost entirely on corporate balance sheets where non-performing loans are growing at an exponential pace.
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The good news is that at least initially the EM credit multiplier is far higher than in the DM.
The bad news, is that even the stimulative effect of the EM multiplier is now fading.
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As a result, instead of going toward economic growth, even EM credit creation has been corrupted by the “western” bug, and is being allocated toward asset-price inflation… such as housing and markets.
[26]
* * *
The above lays out the market dynamic that took place largely uninterrupted from 2008 until the end of 2014.
And then something changed dramatically.
That something is what we said started taking place last November when we pointed out the “death of the petrodollar [27]“, when as a result of the collapse in oil prices oil exporters started doing something they have never done before: they dipped into their FX reserves and started selling. This reserve liquidation first among the oil exporting emerging market, is essentially what has since morphed into a full blown capital flight from the entire EM space, and has also resulted in China’s own devaluation-driven reserve (i.e., Treasury) liquidation, which this website also noted first back in May.
As King simply summarizes this most important kink in the story, after years of reserve accumulation, EMs have now shifted to reserve contraction which, in the simplest possible terms means, “money is being destroyed” which in turn is the source of the huge inflationary wave slowly but surely sweeping over the entire – both EM and DM – world.
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Ok, EMs are selling. But where is the money going? And won’t dumping of Treasurys push yields higher. Answering the second question first, we remind readers of a note from several weeks ago titled “Why China Liquidations May Not Spike US Treasury Yields [29]” which is precisely what DB also said, and which Citi agrees with: while there may be upward pressure on yields it will likely be temporary, especially if there is an even greater risk-aversion reaction in risk assets. The result to EM TSY selling would be a selloff in stocks, which in turn would push investors into the “safety” of bonds, thus offsetting Chinese selling.
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But while one can debate what the impact on money destruction would be on equities and treasurys, a far clearer picture emerges when evaluting the impact on the underlying economy. As King, correctly, summarizes without the capex boost from energy (which won’t come as long as oil continues its downward trajectory), and DM investment continues to decline, there is an unprecedented build up in inventory, which in turn is pressuring both capacity utilization, the employment rate, and soon, GDP once the inevitable inventory liquidation takes place.
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The take home is highlighted in the chart above, but just in case it is missed on anyone here it is again: the “fundamentals point overwhelmingly downwards.”
But wait, won’t central banks react this time as they have on all those prior occasions (QE1, QE2, Operation Twist, QE3, BOE QE1, BOJ QQE1, ECB QE1, etc)? Well, they’ll surely try… but even they know that every incremantal attempt to stimulate the private sector will have increasingly less impact. In other words, the CBs are not out of firepower, it is just that their ammo is almost nil. The reason for that: the “multiplier have fallen” because after 7 years of doing the same thing, this time it just may not work…
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Furthermore, while we have listed the numerous direct interventions by central banks over the past 7 years, the reality is that an even more powerful central bank weapon has been central bank “signalling”, i.e., speaking, threatening and cajoling. As Citi summarizes “The power of CBs’ actions has stemmed more from the signalling than from the portfolio balance effect.”
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So now that the “signalling” pathway is fading, all that’s left are the flows – the same flows which, with very good reason, left David Tepper scratching his head [20]. Flows, which, when one takes into account emerging market reserve liquidation to offset central bank purchases, paints a very ugly picture: one in which the central banks are for the first time since 2009, finally losing control as their inflows are unable to offset the EM outflows.
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Where does that leave us? Well, all else equal, the New New Normal, the world in which central banks are no longer in control as a result of EM reserve liquidation, will be world in which slower credit growth translated into, you guessed it, slower overall growth, or as Citi states the conudnrum: “Even a deceleration in credit growth is negative for GDP growth.”
This is precisely the secular stagnation which we have been warning about since 2009.
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* * *
What is the conclusion?
It’s not a pretty one for either the central bankers, nor the Keynesian economists, nor those who believe asset prices can keep rising in perpetuity, because it means that payment for the free lunch from the past 7 years is finally coming due.
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But at least it is a simple conclusion: we are now at the credit plateau, or as Citi puts it: “Credit growth requires willing borrowers as well as lenders; we may be nearing the limits for both.”
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