What will happen when China implodes?

I just took part in a panel debate about the shape of the global economy.  As a renowned economist (?), I was honoured to be invited and gave my views alongside Shah Gilani, editor of Money Morning and The Money Map Report, and chaired by Andrew J. Barden, Bloomberg’s managing editor for international government in Europe and the Middle East.

As the discussion progressed, it became gloomier and gloomier.  We began talking about regulation, which I described as a reformation of the system.

The regulatory landscape is a deluge of change driven at a global level by Basel III and the regional restructuring created by Dodd-Frank in the USA, the Banking Union in Europe, alongside the Banking Reform Act in the UK.

These regulatory changes are dramatic, and intended to address the systemically important financial institutions (SIFIs) that are too big to fail (TBTF) by creating:

• Living wills;
• Much higher Tier 1 reserves;
• Ratios of leverage and liquidity that maintain stability;
• New governance requirements;

and much, much more.

The net impact of all this change has been the closure of proprietary trading by the Volcker Rule and the ring-fencing of commercial and retail banking from investment banking.  In fact, it’s pushed the banking system into a fundamental reformation of its whole ethos so seeking alpha by trading on the bank’s own book of business.  That trading created the culture of treating customers like muppets and rigging markets for interest rates and FX.  That culture has to be wiped out.

It is intended to bring us back to socially useful banking with a moral compass centred on the good of society.  It is a radical difference from the bonus swilling Wolf of Wall Street culture that created the American Psycho (both in fiction and reality).

Has we achieved these aims?  Is the broken system cured?  Have we reached the end yet?

No.

In my view, there is still a long way to go in reconstruction of the banking system, and the introduction of all this regulatory deluge is only just showing its teeth.  We won’t know we’ve fixed the system until, as Bob Diamond (the then CEO of Barclays) put it, the culture is right.  He defined culture in his BBC 2011 lecture as “how people behave when no-one is watching”..

That’s a tough call, and I definitely don’t think we’re there yet.

But we are seeing the reformation of the system.  From having several European pretenders to battle against the Goldman Sachs crown in capital markets, we now have none.  Barclays is a shadow of its former self, shedding jobs across the board in Barclays Capital.  From acquiring Lehman Brothers US operations, Barclays moved onwards and upwards under Bob Diamond.  Now, in 2014, the results look very different.

This is in part because trading in fixed income and commodities is tougher these days, but also because Diamond has gone and Antony Jenkins has taken over with a wish to transform the bank into a better bank.  In doing so, he is taking an axe to the investment banking arm.  Under a program announced in May 2014 called Project Electra, the balance sheet of Barclays Capital is being slashed in half, resulting in the loss of 7,000 jobs or a quarter of all staff in that side of the bank.  That’s pretty dramatic and is the reason why I hold the flame for them when showing how far the banking system is being reformed.

Meanwhile, this reformation is creating a drive to other vehicles for risk.  The flight to safety we saw with gold and oil since 2008 has plateaued.  The property markets have bubbled everywhere, no more so than in London where the average house price in 42 of the 51 London post codes (zip codes) is now over £1 million and, in 11, is over £2 million.

Investors seeking alpha are now being hoovered up by private equity and hedge funds into new growth markets, but where are those growth markets?

Some see them as being fintech ($10 billion in last four years), but there are others in technology in general – the internet of things, wearables, etc – and, in particular, in life sciences.

These markets will create the next generation of alpha, along with emerging and growth markets.  Post-BRIC emerging markets forecast in the last decade, we now have MIST – Mexico, Indonesia, South Korea and Turkey – or MINT – Mexico, Indonesia, Nigeria and Turkey.  We also have CIVETS – Colombia, Indonesia, Viet Nam, Egypt, Turkey and South Africa.

Obviously, Egypt is more questionable in forecast after the Arab Spring and Turkey is being hit by ISIS and the Syria battles, but there’s no doubt that we see growth in South-South trade.  South America, Asia and Africa all hold keys to our future alpha returns, far more than Europe and, to a lesser extent, America.  This is because of the vast untapped potential of countries such as Nigeria, South Africa, Kenya, Uganda and more.  In fact, I tend to see the next generation of return coming from the countries China does business with, as those are the markets where China sees future potential.

But China itself holds the key to our economic conundrum for the future.

China: a vast market that has seen 15 years of unparalleled growth and sees its primary objective of sustaining that growth at all costs; and there are costs.

China has created the one of largest shadow finance bubbles we’ve ever seen.  Shadow banks, which barely existed before China’s credit surge in 2009, now have assets of at least 30 trillion yuan ($4.9 trillion), or more than 50% of GDP, according to estimates by ANZ.  In other words, China has a commercial growth bubble and a property bubble, sustained by that shadow finance bubble.

What is the risk of the shadow finance implosion and what will the world’s economy do to recover when that happens?

When China implodes … what will happen?

Now, there’ s a cheery start to your Monday morning but, just to finish on a more balanced note, you know that the collective noun for a group of economists is a confusion, so here’s the latest forecast for China from The Diplomat.

Growth predictions for China’s long run issued by the IMF and the Conference Board in recent days have not been positive. The IMF has projected that growth will not reach above 6.5-7 percent in 2015, while the Conference Board projects that China’s growth will slow to 5.5 percent annually between 2015 and 2019, falling to 3.9 percent per year between 2020 and 2025.

China has recently been hit with lower growth as it struggles to emerge from under excessive debt in the corporate sector and restructure its economy. The drag on the economy due to a large amount of debt in fixed asset investment sectors such as real estate has required a pullback in bank lending and reduced growth levels. At the same time, as China turns away from labor-intensive manufacturing to higher value-added manufacturing and services, policies and institutions that assist the restructuring process have lagged behind. GDP growth in the third quarter of this year has been announced at 7.3 percent, lower than the target of 7.5 percent.

At this point, uncertainty reigns.

Did I say a collection of economists is a confusion?