Apr
We aren’t going to refer to “diminishing returns” in the microeconomic sense (as a decrease in the marginal output correlated with an incremental increase of a single factor of production) but rather in a broader manner, by taking a look at just how much of an increase in credit-fueled firepower is necessary to maintain economic growth, not just in China but in the West as well.
As a bit of a textbook example, it “only” took approximately 6.5 trillion CNY in terms of new credit creation to achieve roughly 5 trillion CNY in terms of growth in China back in 2007. Eight years later, three times more credit creation was necessary to achieve the same result and this is precisely the phenomenon type we are referring to when using the “diminishing returns” expression.
Furthermore, it is pretty much common knowledge that the Communist Party of China is interested in keeping economic growth at a reasonable rate so as to avoid civil unrest scenarios. While the authorities are well-aware of the fact that the double-digit GDP growth rate days are (long) gone and that it would be unrealistic to attempt to stimulate your way toward the unsustainable, they are coming to terms with the fact that even robust single-digit growth is harder and harder to come by.
China has been able to avoid a recession for not years but downright decades and as far as the West is concerned, it seems that for many market participants, the days of the 2007-2008 Great Recession and its aftermath have been all but forgotten. In fact, from the perspective of let’s say the average US citizen, never before has it been this long between recessions, with stock markets at all-time highs and asset prices at impressive levels prior to the 2020 covid-19 situation.
No recessions, sky-high asset prices and so on… it does seem like a paradigm shift, does it not?
Indeed, and this is precisely why “prudence” should have been the operative word well before the coronavirus situation.
The ChinaFund.com team cannot stress this enough: in our view, the previously mentioned “prosperity” is let’s not say fake but instead, we will call it “paper” prosperity. Not only that but based on the same principle described for China previously, this prosperity came with a remarkably high price tag in terms of fiscal and especially monetary policy:
- In the United States, more money has been injected into the financial system in just one year at the height of Quantitative Easing (roughly $1 trillion) than had existed in the monetary system after almost 100 years, from 1913 when the Federal Reserve was created up until the Great Recession. Furthermore, interest rates have been brought all the way down to zero and despite having gone up prior to the Fed bringing them back down to combat the economic effects of the covid-19 economic shutdown, were still remarkably low historically-speaking
- Over in the European Union, even more has been done in terms of aggressiveness, with interest rates flirting with negative territory and more money being “printed” at the height of EU QE compared to the US counterpart
- Let’s not even refer to Japan, with its debt to GDP ratio north of 200% and which can be considered the “pioneer” of unorthodox monetary policy
To put it differently, it should be crystal-clear that growth didn’t just come with a steep price tag over in China, things were equally tricky in the proverbial West. To anyone who cares enough to pay attention, it would have been more than obvious that absolutely nobody wanted to even accept the possibility of a recession occurring. Furthermore, as became obvious back in 2007-2008 (in a considerably less unorthodox climate), even a small blip on the recession radar is enough to bring the worldwide financial system to its knees.
Financial system first and foremost.
Why?
One word: leverage.
To be more precise, our financial system is so over-leveraged that you essentially have trillions of US dollars of derivatives on top of billions of US dollars in assets. In a far less leveraged framework, something along the lines of let’s say -4% GDP growth (“negative” growth, as a bit of tongue in cheek reference) would of course be unpleasant… but not devastating.
In 2020 and beyond, GDP reductions (to be more blunt) and even stagnation represent a systemic threat. For this reason, it is the number one nightmare of any government for things to break on their proverbial watch and as such, kicking the can down the road for yet another cycle has become the norm rather than an extraordinary approach. We have essentially accepted the unsustainable as status quo.
With each cycle that passes, the additional layer of dovish fiscal and especially monetary polity becomes more and more impressive. In the aftermath of the Dot-Com Bubble, Alan Greenspan bringing interest rates down to 1% was considered ultra-aggressive. Fast-forward to the aftermath of the Great Recession, and zero-bound interest rates correlated with injections that amounted to as much as $1 trillion per year became acceptable. This time around, perhaps the US will also flirt with negative interest rates, the European Union might go deeper into negative territory and the list could go on and on.
Unsustainable?
Yes.
Predictable?
No.
Perhaps 2020’s economic downturn will prove to be the fatal last wrench in the global economy’s system of cogs. Then again, maybe the can will be successfully kicked down the road, with the implications becoming the next administration’s problems.
The ChinaFund.com team has no idea WHEN this unsustainable system of diminishing returns, of adding more and more gasoline to the economic fire for the sake of preserving the status quo, will ultimately break. But we are quite confident it will and in our view, the best possible time to hedge was yesterday. The next-best time would be right now because the benefits associated with smart hedging are so asymmetrically in your favor at this point, that it would be a severe mistake to remain passive… in our opinion, at least. Should you be interested in help with respect to doing just that, we are only a quick message away.