Monday, 17 March 2014

China: don't be fooled by the availability bias

Will the Chinese credit bubble, much of it reliant on shadow banking financing, lead to a major financial crisis in the country and drag down the global economy?

China is well known for its opaque statistical data. This renders a detailed and reliable assessment of the country's credit bubble basically impossible.

However, sometimes there are situations where by just keeping things simple, focusing on the big picture and quantifying it, we are able to reach robust enough conclusions to spare us from having to spend ages delving into detail. China's credit bubble is one of these situations.

There are many thing we don't know about China. And two we know for sure:

1. China has been running continuous current account surpluses for the past 20 years......
.....with the country's foreign exchange reserves peaking at USD 3.8 trillion in December 2013 (approximately 45% of GDP). This means that the Chinese economy is not dependent on external financing to pay for its imports (including raw materials, intermediate and capital goods). A sudden stop cannot occur (meaning: no danger of disruptions in Chinese production, demand and international supply chains). Unless a massive flight of capital from China were to take place.

2. China macroeconomic framework doesn't allow for free movements of capital. The capital account is closed. With a closed capital account there can be no massive flight of capital out of the country. So, a sudden stop cannot occur. Really.

The Chinese government has therefore all the resources needed to avoid a massive financial crisis. Or putting it differently: for a devastating financial crisis in China to occur one has to assume that the Chinese government (a) is not aware that one can occur or (b) is aware that it can occur, but not willing to avoid it via a bail-out of the financial system when, and if, push comes to shove.

Neither (a) nor (b) apply. The Chinese authorities are very aware and vigilant of the excesses in the financial system as their recent public statements show. And they will not risk a major financial crisis and the resulting potential social and political tensions. They may not be happy bailing out large parts of their financial system. They may even think that bail-ins and debt-to-equity swaps would be a more effective way to deal with the problem on a longer-term perspective. And they are certainly aware that bailing-out large parts of the financial system is de facto protecting past and  incentivising future misallocation of resources in the economy, which will unavoidably impact negatively the economy's long-term growth potential. But in the end they will have to act in a way consistent with the the communist party's dominant political objectives. And these happen to be economic development and keeping social and political stability at all time. It follows that massive intervention and bail-outs, if needed, will occur.

Why then do many of us in the West tend to think that a financial crisis is likely to occur in China? Human behavioural biases are at work: availability bias / representativeness heuristics, i.e., recent large scale events tend to feature predominantly in our memory and shape our perception of the world. Having gone through the largest financial crisis of our lifetime, we tend to focus on apparently similar imbalances to the ones that led to "our" financial crisis, ignore the differences (e.g. the FED's disregard for the dangers of sub-prime debt vs. the Chinese authorities' focus on the dangers of their credit bubble) and over-extrapolate. The result is that we are likely going to predict 20 out of the next 2 financial crisis.

Am I simplifying too much? I don't think so. And recommend that you keep it simple: if markets were to come down by 15%-20% as a result of a supposed Chinese financial crisis triggered panic, please remember Warren Buffett and "be fearful when others are greedy and greedy when others are fearful".

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