There are echoes of the Lehman crisis in China’s money market

Allister Heath
WHEN you remove a drunk’s supply of alcohol, they tend to get very tetchy very quickly. In the case of the global markets, hooked to Fed intervention since the 1990s, merely talking about the likelihood of curtailing cheap money, their drug of choice, triggers immediate panic.

There was a sea of red yesterday, with the Vix risk index seemingly the only measure on the rise. Gold is plummeting, destroying the old rule that it goes up when other markets go down. Assets have become correlated, wiping out some naïve investors who thought they were hedged.

The reality is that several factors are coming together to create a perfect storm. First, the Fed is eventually going to start tapering its QE. Though not exactly a drastic move, everybody is panicking. It is worth pointing out that the usual measures of inflation show that price pressures in the US are very weak. But the problem is that the Western world’s obsession with consumer price stability (rather than monetary stability) in recent decades has allowed it to turn a blind eye to bubbles in asset prices, and other distortions, as long as the prices of goods and services have remained stable. So low CPI readings are not a sufficient reason for continuing with ultra-interventionist monetary polices, especially given that the US banking system and housing market have both been purged of their excesses and malinvestments, something that is not necessarily true in other countries. It is vital that proper market forces be reintroduced into the system.

Second, China is slowing and its markets may even be facing an unprecedented meltdown, one eerily reminiscent of what happened in the US when Lehman Brothers imploded. The Shanghai Interbank Offered Rate (or Shibor, China’s equivalent to Libor) has shot up in recent days, with rattled local banks becoming increasingly unwilling to lend to one another. Liquidity has taken a hit; one analyst, Patrick Chovanec, chief strategist at Silvercrest Asset Management, has gone as far as to claim that the interbank market is no longer functioning. When the equivalent freeze happened in London, and the US money markets stopped working, the entire global economy almost came crashing down, so investors who are selling off bonds and equities are right to be apprehensive. While the Fed has signalled that it wants to reduce its interventions, the Chinese monetary authorities have already started to step back, at least when it comes to the provision of liquidity to the interbank market. This is one of the most significant developments of recent days – unlike the Fed’s actions, which were hardly unexpected, this latest phase in the Chinese slowdown has caught most external observers by surprise.

But even if the Shibor calms down again, or if the People's Bank of China does step in, the big picture remains. Growth is slowing, and the country has gone through a massive credit and property boom; it remains an open question as to whether it will be able to cope in any transition to more normal circumstances.

Third, and most important of all, the secular decline in the cost of borrowing and bond yields – caused by reduced investment rates in the West after the post-war reconstruction boom ended, which for years weren’t fully matched by increased spending in the East, and which caused a fall in demand for funds globally -- and reinforced by central bank manipulation of markets, is coming to an end. The new trend is for higher rates, reversing a process that started in the 1980s.

This is much bigger even than the end of QE. An increased cost of borrowing will gradually deflate all of the bubbles around the world – but it will also reduce the number of viable projects. We have barely even started on the long journey towards a more normal economy. Yesterday’s chaos in the markets is just the start.
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