From David Stockmans Contra Corner
Our point yesterday was that the Fed and its Wall Street fellow travelers are about to get mugged by the oncoming battering rams of global deflation and domestic recession.
When the bust comes, these foolish Keynesian proponents of everything is awesome will be caught like deer in the headlights. That’s because they view the world through a forecasting model that is an obsolete relic—one which essentially assumes a closed US economy and that balance sheets don’t matter.
By contrast, we think balance sheets and the unfolding collapse of the global credit bubble matter above all else. Accordingly, what lies ahead is not history repeating itself in some timeless Keynesian economic cycle, but the last twenty years of madcap central bank money printing repudiatingitself.
Ironically, the gravamen of the indictment against the “all is awesome” case is that this time is different——radically, irreversibly and dangerously so. High powered central bank credit has exploded from $2 trillion to $21 trillion since the mid-1990’s, and that has turned the global economy inside out.
Under any kind of sane and sound monetary regime, and based on any semblance of prior history and doctrine, the combined balance sheets of the world’s central banks would total perhaps $5 trillion at present (5% annual growth since 1994). The massive expansion beyond that is what has fueled the mother of all financial and economic bubbles.
Owing to this giant monetary aberration, the roughly $50 trillion rise of global GDP during that period was not driven by the mobilization of honest capital, profitable investment and production-based gains in income and wealth. It was fueled, instead, by the greatest credit explosion ever imagined——$185 trillion over the course of two decades.
As a consequence, household consumption around the world became bloated by one-time takedowns of higher leverage and inflated incomes from booming production and investment. Likewise, the GDP accounts were drastically ballooned by a spree of malinvestment that was enabled by cheap credit, not the rational probability of sustainable profits.
In short, trillions of reported global GDP—–especially in the Red Ponzi of China and its EM supply chain—–represents false prosperity; the income being spent and recorded in the official accounts is merely the feedback loop of the central bank driven credit machine.
But now we are at the credit bubble apogee. Nearly every major economy of the world is being freighted down with debilitating levels of debt. By some sober estimates upwards of 20% of China’s monumental $30 trillion debt pile may be non-performing, and that means that the parallel credit mountains among its supplier base are equally imperiled.
Indeed, the credit ponzi at the heart of the global economy has reached the classic breaking point. Last year China generated nearly $2 trillion in additional debt, but nearly all of it went to paying interest on existing obligations. It is only a matter of time before the $30 trillion house of debt cards there comes violently tumbling down.
Nor is this just an EM world disability. The old age colony on the Japanese archipelago has a 400% debt to GDP ratio, and most of the world by McKinsey’s reckoning a year ago is not far behind.
Accordingly, the defining condition in the years ahead will be the inverse of the 20-year credit bubble. At peak debt, the world’s economies will struggle with delinquencies, defaults, write-offs, plunging profits, impaired assets and collapsing valuation multiples.
Source: IMF World Economic Outlook Database, October 2015.
Needless to say, the Keynesian narrative denies that the above displayed 5% dip for 2015 is relevant or, more importantly, that it marks the beginning of an unprecedented downward plunge that may last for years to come.
Instead, our learned PhDs assure that the world economy is growing at a swell 3-4% rate on a currency and inflation adjusted basis. Indeed, in terms of purchasing power parity (PPP) most of the world has purportedly never had it better.
Here’s the thing. The world runs on dollars, not on the statistical abstractions like purchasing power parity that are spit out of academic macroeconomic models. In fact, upwards of $4 trillion in currency trades occur daily in futures, options and forward markets, and virtually all of them are in nominal dollar pairs or dollar referenced crosses.
There are no trades in “real” dollars, currency adjusted GDP or units of PPP. And that’s profoundly important because the entire $225 trillion global debt bubble is anchored in dollars.
That is, it is either denominated in dollars directly such as the $60 trillion of domestic credit market debt or the $10 trillion of dollar dominated off-shore bonds; or it is denominated in the “near-dollars” generated by off-shore banking systems and domestic bond markets.
Stated differently, euros, yen, yuan, won, ringgit and even Saudi riyals are near-dollars. The currently outstanding debt denominated in all of these currencies arose in domestic credit markets that were fundamentally shaped by the dollar policies of their respective central central banks.
The short-hand essence of it is that the Fed printed and the PBOC, ECB, BOJ and all the rest printed, too. Overwhelmingly, this was done in the name of export mercantilism under which currencies were pegged to the dollar to keep exchange rates artificially low so that exports would continue to flow.
Needless to say, this relentless exchange rate pegging caused foreign central banks to accumulate massive dollar reserves, and to propagate domestic credit within their own banking and financial system on a reciprocating basis. In sequestering dollars, for instance, the PBOC created massive amounts of new RMB.
And so the world’s mountain of dollar and near-dollar debt grew like topsy.
Thus, the PBOC did not increase its so-called FX reserves by 80X after 1994 because Mr. Deng and his successors were saving FX for a rainy day; they were bailing-in dollars earned from their export machine and pumping RMB back into their domestic credit market at an historically insane pace.
Likewise, Saudi Arabia earned massive amounts of inflated dollars as the global credit and CapEx bubble created an unquenchable thirst for oil and unprecedented windfall rents at $100 per barrel. But the Saudi central bank kept its currency rigidly pegged at 3.8 riyal/dollar, thereby causing an enormous expansion of its balance sheet and domestic credit.
Indeed, domestic Saudi bank lending grew at 20-40% annual rates during the first oil bubble, which peaked at $150 per barrel in 2008, and continued to expand at 10-20% annual rates until the world oil price break in June 2014.
At the end of the day, the Fed led central bank money printing spree of the past two decades resulted in what is functionally a massive dollar short. Once the Fed stopped expanding its balance sheet when QE officially ended in October 2014, it was only a matter of time before all the “near-dollars” of the world would come under enormous downward pressure in the FX markets.
Our Keynesian witch doctors believe that sinking currencies are a wonderful thing, of course. They claim making your country poorer is a good way to stimulate exports and a virtuous cycle of spending and GDP growth.
But there is another thing. It is also a good way to generate capital flight and an eventual need to shrink internal banking and credit markets in order to stop a total FX meltdown. That’s exactly what is happening in China and throughout the EM today.
The case of China is well known. It has experienced upwards of $1 trillion of capital outflows during the past 15 months, and that’s in spite of $350 billion current account surplus during this period. Accordingly, the PBOC has permitted the exchange rate to drop by about 6% and, on a supplemental basis, has brought out the paddy wagons to arrest people and capital attempting to flee the faltering Red Ponzi.
Still, unless it can impose an absolute financial police state, China’s days of rampant domestic credit expansion are over. It will be selling down its already diminishing trove of FX reserves to prevent the RMB from descending into a total free fall; and, so doing, it will unavoidably shrink credit in its internal banking system, as well.
The Chinese implosion will take some time to unfold because the red suzerains of Beijing are abysmally ignorant about the laws of markets and sound money and credit. So they are content to paint themselves ever deeper into a corner via short-term expedients designed to keep the credit ponzi from collapsing. Yet these increasingly desperate measures are destined to fail, meaning there will be an even more devastating implosion at the end.
By contrast, Brazil is the poster boy, and reflects an already advanced case of dollar deflation. Its socialist governments of the last decade had a special penchant for financial profligacy and corruption, but it did not impose a financial police state as China is now doing.
So capital is fleeing in droves and the huge current accounts surpluses it earned as an epicenter of China’s post-2008 eruption of demand for commodities and raw materials like iron ore are drying up.
Needless to say, this gathering implosion comes on the back of an epic boom. Between 2005 and 2011, Brazil’s dollar denominated GDP grew explosively from $900 billion to $2.6 trillion or at what amounted to a lunatic annual rate of 20%.
In the process, its central bank balance sheet, external dollar borrowings and internal domestic currency based credit grew apace. On a dollar basis, for example, credit extension to the private sector grew at a 27% annual rate during the boom period.
Those kinds of double digit annual gains were typical of Brazil bounding forward on the up-ramp of the global credit spree. While the Brazilian central bank generally tried to peg the exchange rate so as to keep the Brazilian export machine competitive, it was not completely successful and thereby ended up with the worst of both world. Namely, a large influx of hot foreign capital, and an inordinate and unsustainable expansion of its domestic credit levels, too.
Since the bursting of the global commodity bubble in 2012-2013, Brazil’s exchange rate has been in free fall, reflecting its rapidly shrinking current account, intense capital flight and the market’s recognition that its debt bloated economy is a slow motion trainwreck.
Accordingly, the Brazilian real has lost nearly two-thirds of its peak value against the dollar. More importantly, it has forced Brazil’s central bank to push interest rates well into double digits, thereby shrinking domestic credit in real terms, even as the economy continues to contract.
In short, the Brazilian boom has ended, and its domestic economy is now sinking into the worst recession since the 1930s. And in dollar terms, the picture is especially stark. Brazil’s dollar GDP by the end of 2014 had already plunged by 11.5% from its 2011 peak.
This year it will be down another 5% and the bottom is nowhere near in sight, as Brazil’s downward economic spiral is being exacerbated by an existential crisis of governance (i.e. multiple corruption probes and impeachment campaigns against the President and legislative leaders).
Our Keynesian snake oil salesman will say that the implosion of Brazil’s dollar denominated GDP is all to the good. That foolish proposition is based on the same old FX depreciation error that they have been peddling for decades, and which the IMF has imposed on over-indebted countries with such universally devastating results.
The fact is, Brazil’s real economy is in free fall because its public and private balance sheets are falling apart, and because external demand for products from its inflated export industries continues to sink as the Red Ponzi unwinds.
You could not find any more dramatic case of massive malinvestment than in Brazil’s iron ore industry, which is now stranded high and dry as global prices sink toward $30 per ton compared to the boom time peak of $200. And the distress in iron ore is feeding through the entire Brazilian economy.
Thus, overall industrial production was down nearly 12% on a year-over-year basis in October, and is forecast to continuing sinking in the year ahead.
Why this matters is that the credit boom was global. As the implicit dollar short unwinds in China and among its EM suppliers, the petro-states and elsewhere, no financial markets anywhere on the planet will escape the collateral damage.
That is to say, large chunks of the world’s $225 trillion of debt will default and be written down or liquidated as the global recession gathers momentum. That means, in turn, that the vast equity bubbles which have been levitated by the false credit and economic expansion of the past two decades will implode, as well.
There is probably no better illustration than Brazil’s own crumbling national champion, Petrobras. The combination of $100 per barrel oil, unlimited debt availability and madcap drilling in the deep offshore brought global speculators pouring into its stock. Accordingly, Petrobras’ market cap exploded by 25X, rising from $15 trillion in 2002 to a peak of $375 billion late 2011.
Now, of course, oil is in the $30s, access to new debt is long gone and the drilling program has gone bust in a mess of corruption and failed economics. Consequently, $350 billion of bottled air has vaporized.
PBR Market Cap data by YCharts
In the aftermath of the giant global credit bubble, there is no such thing as a “decoupled” US economy. The implosions of China, Brazil, the rest of the EM, the petro states and the likes of Petrobras will be lapping up on these shores soon.
And that’s when the Keynesian “all is awesome” delusion will get mugged good and hard.
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