UBS strategist George Magnus helped popularize economist Hyman Minsky’s thinking in the runup to the financial crisis by warning of the likelihood of a “Minsky moment.” For those not familiar with Minsky’s work, a short overview from ECONNED:
Hyman Minsky, an economist at Washington University, observed [that] periods of stability actually produce instability. Economic growth and low defaults lead to greater confidence and, with it, lax lending.
In early stages of the economic cycle, thanks to fresh memories of tough times and defaults, lenders are stringent. Most borrowers can pay interest and repay the loan balance (principal) when it comes due. But even in those times, some debtors are what Minsky calls “speculative units” who cannot repay principal. They need to borrow again when their current loan matures, which makes
them hostage to market conditions when they need to roll their obligation. Minsky created a third category, “Ponzi units,” which can’t even cover the interest, but keep things going by selling assets and/or borrowing more and using the proceeds to pay the initial lender. Minsky’s observation:
Over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight of units engaged in speculative and Ponzi finance.
What happens? As growth continues, central banks become more concerned about inflation and start to tighten monetary policy, meaning that
. . . speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently units with cash flow shortfalls will be forced to try to make positions by selling out positions. That is likely to lead to a collapse of asset values.
From that, Magnus coined “Minsky moment” in early 2007, which occurs when
…lenders become increasingly cautious or restrictive, and when it isn’t only over-leveraged structures that encounter financing difficulties . . The risks of systemic economic contraction and asset depreciation become all too vivid.
Given that Magnus was one of the few prior to the financial meltdown (and not too long before either) to see the possibility of a generalized credit contraction, as opposed to, say, a “contained” subprime crisis, his warning on China is worth considering. He highlights, as other commentators have, that China’s dependence on investments, now 47% of GDP, is unprecedented, particularly in a large economy. In addition, half that total is in property investments, which is not necessarily productive.
But what troubles Magnus most about Chinese investment is the degree to which it depends on lending. From the Financial Times:
But a more immediate worry is the growing credit intensity of China’s economy. What China calls “total social financing” – conventional bank loans and most other external sources of finance – was still 38 per cent of GDP in the first quarter of 2011, almost as high as in 2009 when China implemented a credit-centric stimulus programme. The credit intensity of growth, or the amount of new credit generated for each unit of GDP growth, has risen from 1-1.3 before 2009 to 4.3 in 2011.
Despite a 500 basis points rise in bank reserve requirement ratios since January 2010, and four 25bp increases in interest rates since October, credit demand and supply seem barely affected. In real terms, interest rate levels are the lowest for 13 years: the three-month deposit rate stands at -3 per cent, and the one-year lending rate at 1 per cent. Companies are borrowing more as cash-flows weaken, with energy, utility and wage bills rising.
Although formal bank loan volumes are subject to restraint, they only comprise about half of TSF. Companies can also access plentiful liquidity in Hong Kong, where the renminbi deposit market has increased eightfold since mid-2010 to more than RMB400bn and where offshore renminbi financing is rising fast….
But financial instability, arising from excessive credit, increasing inflation and weak investment returns, is always an important catalyst…..In this, the leadership changeover in 2012, a reluctance to compromise growth or alienate workers, and political interests in rising property prices could lead to a premature call of victory over inflation. This might boost asset price and growth in the short term, but increase the likelihood the new leadership will have to deal with a credit-fuelled Minsky moment.
Magnus does depict another set of choices which would steer clear of that result, that of increasing interest rates both to stanch inflation and shift the economic model away from lending-stoked investment towards more consumption. But putting on the brakes will slow growth short term. This is a tricky bit of economic management, and as the experience in the US and other major economies in the 1970s and 1980s showed, politicians are reluctant to induce a recession (which is what it might take in China to shift gears) until the alternative is painful. And even then, the temptation is to abandon the course. Carter pressured Volcker to abandon his squeeze on financial firms and the economy generally; can you imagine either Greenspan or Bernanke showing Tall Paul’s resolve? Today’s nominally independent Fed chairmen have been pre-screened for their bankster friendliness.
Given that preventing labor unrest is a major priority in the Chinese officialdom, it seems they have a non-win situation: either see worker real incomes squeezed further by rising prices, or deprive some, perhaps many, of jobs by putting the brakes on growth. As much as the entire world has every reason to hope for a happy outcome, soft landings are notoriously hard to engineer even in a command economy like China’s.