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The view from Singapore

And so, after four months of enforced idleness thanks to the vengeful nature of my former employer – I’m back in a chair, poring over my screens to once again try and make sense of the world. I’ve been fortunate enough to move to Singapore, and if any readers know smart, curious and friendly folks out here I should be connecting with please do take the time to tell me who they are. A couple of weeks back I wrote a quick summary of how I thought things might have gone during my time off – and wanted to check back in to see how I did!

Firstly, what seems clear is that there is one main show in town. If one compares M3 growth to nominal GDP growth across the major economies, not one is growing faster than the 5y average. Global monetary conditions are tightening across the board. The biggest deflators, relatively, are the US and Australia. Both have money growth slower than NGDP growth – so are tightening both relatively and absolutely. My first expectation was that the market would be anticipating the Fed tightening to the point of recession, but despite the selloff in equity markets in october – the picture post mid terms is much rosier than I expected in the market’s collective mind. The curve is steeper – implying a more orderly tightening. Equity markets are recovering, albeit not as quickly as many would like. However if you talk to people they will earnestly tell you they are expecting recession and slowdown in 2019/20 – and indeed some of the big american banks have made this call with JP Morgan calling for a recession in 2020. To me, the market seems ripe for this narrative to be picked up in the new year – and so the current pricing of interest rates seems far too agressive. The peak of the forwards curve is at 3.40 in the US and I would expect that to come down to just above 3% in an economically bearish scenario. The theatre of Democrats subpoenaing Trump acolytes left right and centre might provide a catalyst for that, as might the prospect of a government shutdown. Moderates did not do well in the mid terms – so Democrats ought to be spoiling for a budget fight.

The other big potential catalyst is Australia -where the combination of central bank complacency and housing market weakness remains a powerful driver. Still the most deflationary monetary environment in the developed markets, and with an outsized financial sector (40% of the stock market!) – Australia is the prime candidate for a financial market induced slowdown. US rates are probably the better play – and option structures that would do well from Australia => US contagion look more attractive than piling into the already well received Australian interest rate market to me. I think that broadly speaking I got this one right – and receivers of Australian rates have been well enough rewarded -especially if done vs USD.

As regards Europe, the view from this side of the world is cloudy. Spreads remain wide and every day brings news of further tensions between the Italian Government and the European institutions. However, all of this still looks to be a red herring. What matters is ECB policy – and no matter what constraints are there legally and practically to keeping an insolvent Italy in the zone through monetary chicanery – the baseline assumption has to be that the ECB will find a way. It is, institutionally, one of the worlds most independent and powerful central banks. In a fight between it and the current government, I would take the ECB every time.

FOR THE RATES MARKET PROS: A neat tactical play for near term worries is provided by a previous bit of ECB intervention. A large chunk of TLRTO money (loans the ECB made to eurozone banks at highly preferential rates) becomes too short for banks to rely on it to goose their NSFR (net stable funding ratios) in the new year – so they will either have to issue paper, borrow in wholesale markets, or the ECB will have to step up again. In its current hawkish messaging –  the latter is less likely.  Paying Bobl spreads here looks a good way to position for eurozone breakup fears and benefit from the coming rush of banks to the market. If anyone wants to tell me I’m wrong because of seasonality, or because the bobl future is too rich on the curve then I would love to hear it!

FOR THE NORMAL PEOPLE: The big story of global financial retrenchment is going to be the big story in 2019. Most people are carrying around a model in their heads that says that money was ample for the last 5 years but mysteriously the market didn’t respond. We know they’re wrong. Monetary aggregates have been growing at their normal pace – despite central bank action. The world has moved from a normal environment to a tight monetary environment – and that is going to be the backdrop for markets in 2019. Expect many surprising bearish events – from EM panics to esoteric parts of the developed financial markets blowing up – as $ become scarce everywhere.

 

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What I expect

As I return to financial markets after a 4 month hiatus, I wanted to jot down what I believe to be true so I can compare with what turns out to be true once I sit down in the chair again. I’m sure thinking in many areas has moved on – and I don’t expect this to be right – but I  hope the ways its wrong are instructive, so here goes!

When I left – the US yield curve had already inverted. 3m rates in 2y time were below 3m rates in 1y time – meaning the market had started to price some probability of either Fed tightening or a reduction in nominal GDP growth following rate hikes. In other words, the Fed will tighten to the point of contraction. I don’t expect that belief to have changed in these four months. I’ve avoided most economic news – but the dribs and drabs that come through my twitter feed haven’t indicated the kind of barnstorming US growth that could perhaps change the markets mind on the appropriateness of hikes. I expect to sit down to an inverted forwards curve again, and to no change in the widespread belief that a recession or at least a slowdown is coming in 2019/20.

I expect there to have been bearish changes to the markets view on Italy due to looking ahead to succession at the top of the ECB. By now, a hawkish faction of believers are probably gaining ground and persuading some that ECB policy will become less accommodative with the departure of Draghi and that this will drive greater sovereign spreads. Whilst short term concerns about budget deficits and other faffery may be dominating the headlines – the smart money will have maintained the view that ECB policy is the only meaningful driver of sovereign spreads and will be reluctant to lean against the widening.

The situation in Australia should look quite similar – but I would hope that some have started to see the issues there, with the big contraction in broad money growth that started in late 2017. Unless this has reversed due to unforseen changes to bank lending policy – I would expect that Australian growth is anemic with wages and prices exhibiting decent growth – and there is some hand wringing about the fact that inflation is implying hikes whilst the “tone” of the economy argues for cuts. The RBA appears quite complacent to the decline in broad money – focusing on CPI and the mortgage market – so I would expect the opportunity to receive Australian rates to be in place still.

Let’s see what happens when I turn on my Bloomberg and have a look around at the playing field next week !

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Managing Capitalism

Today finds me, dear readers, in a particularly good mood! Having spent a good number of happy years on the dealing floor of a big bank, I’m heading to another one, and relishing the prospect of several months gardening leave. This is one of the more pleasant side effects of working for gigantic, bureaucratic, paranoid institutions staffed by the risk averse. Despite my general goodwill towards all, my former employer’s paranoia that I would steal clients/knowledge/whatever else forces them to effectively pay me to sit here blogging about my ongoing battle with capitalism rather than working out my notice period. Naturally, they are doing their best to withhold any salary they can , but I’ve no ill will towards them on that score – after all they are responsible to their shareholders. As I leave the firm, I wanted to offer some reflections. People often ask me what it’s like for someone “like me” working for a bank, and it has been interesting! But more than that, I have some recommendations for those who struggle with working under capitalism on how to manage it from a personal perspective. I hope you find them useful!

For starters, I’ve always cast my working life not as a “career” but as a constant negotiation with capital. My starting point is that any employer, being an agent of capitals interests, will be out to get as much possible value from my effort as they can, and share as little of the monetary value of that effort as they can with me. This is not a matter of them being evil and me being righteous, it’s simply a fact of the kinds of institutions that dominate our economic world. As such, I resolved very early on, that I would only make such efforts as I knew would either satisfy me personally, or get me paid better. In my thinking, there is no place for sucking up to ones boss, spending late nights at the office, or other such display activities. I expect to be paid my replacement cost, discounted by the likelihood of my finding alternative employment. At the start of my career, there were few vacancies and many unemployed market makers – so being paid a steep discount to my replacement cost was expected, and I took that wage with no hard feelings whilst my colleagues groused endlessly. One thing that’s amazed me throughout my career is the extent to which capitalist ideology makes my colleagues shocked, SHOCKED!, to discover that they are exploited by the firms they work for. The amount of times I was told “I worked so hard, I DESERVED to get paid this year!” – as though that should have anything to do with it – was bizarre. Perhaps there is a premium to be gained by signalling unhappiness to ones management, though I’ve not seen much evidence for this. What I have seen is the toxic effects on individuals mindset and life satisfaction from really being unhappy. It is a tragic waste. Recognising the reality of the relationship one has with an employer, that they are engaged in exploiting your labour, is very freeing on a personal level.

This is not to say that one should not negotiate aggressively with ones employer, or be satisfied with less. I would always counsel people to stick up for themselves. One of the favorite methods that managers, acting out their role as enforcers for the interests of capitalists, like to use is to appeal to employees decency. The sad reality of such an approach is that the manager and the employee are ALSO having a real relationship, alongside the role that the manager is playing. In my experience, good managers understand this and are open and honest about the role they play in order to be able to also have a real relationship. That takes emotional intelligence, empathy and integrity – attributes sadly lacking in the investment banking world, but luckily so valuable that those who exhibit them can and do succeed wildly. Managers who don’t separate the two, which is most, end up poisoning their relationships with employees by mixing roles and including the demands of capital in their social discourse with employees. That sucks both for the employees and the manager, unnecessarily making both miserable. The method that I’ve found that consistently works is to force an understanding of the separation of roles as quickly as possible. It may sound hard, but telling your manager “I expect to be paid my replacement cost and will act accordingly, I am not relying on your goodwill” is an honest and useful thing. This was a conversation I had early on with the boss that I am quitting on, and straightened our relationship out very well. Of our team, I was the only one they did not undermine or bully – because they understood that my self esteem and expected compensation was not tied to their approval. This was a very valuable experience for me, as it’s the first time for a few years I’ve had a ‘bad’ manager and so needed to implement my theory about how to deal with it and it worked well.

I put bad in inverted commas, because the skills that are required to manage well are in short supply. I do not begrudge any individual with a lack of emotional intelligence or empathy, such a person could and should be valuable and useful if working with sympathetic people in a framework of honesty and trust. Unfortunately, creating such conditions under capitalism is not easy!  Still, we must try. I don’t mind sharing that the initial shock of the conditions at my previous employer caused me serious problems. For a while, I felt quite confused – believing that I was merely struggling to adjust to a new city and situation and it would right itself. Depression, anger and self destructive behaviour followed. Mercifully not for long. Upon realising that something was deeply wrong in my work environment, I resolved to try and do something constructive about it. My efforts were mostly unsuccessful. I like to think that there are some deep cultural problems that there was no chance I could make a dent in, perhaps I am just not that good at creating a positive environment for my colleagues. Either way, my situation improved enormously simply through making the attempt. I felt purposeful and empowered. Being generous and attempting to manage the shortcomings of the environment put me in a position of power. When I saw my efforts making little impact, I was lucky enough to have other sources of self worth to say “ok, no hard feelings, time to go”.

The one key advantage I feel I’ve enjoyed through all of the trials and tribulations that a job on the dealing floor of a big bank brings is that I don’t accept the legitimacy of capitalist relations. I accept that in my own interest, it is often sensible to do what I’m asked by my managers. It’s even sensible to make strenuous efforts whilst working in a capitalist system – so long as those efforts are compensated. Making these efforts can even be pleasant! Being part of an institution with vast amounts of intellectual and human capital allows one to develop ones own capabilities. If others benefit from the value I create, that is fine by me. The world is very much not a zero sum game. What is not good is selling oneself short to satisfy the illegitimate demands of capitalism. It is not your duty to create value for others. It should be a happy side effect of cooperation. None of this is easy. Capitalism creates and perpetuates exploitation on a very personal level. Bullying often gets results, as does manipulation and dishonesty. As soon as one sees this for what it is, it loses its sting. As I enjoy some months to sit and reflect, I intend to write more on how resistance to capitalism on a personal level can be a route to personal and professional fulfillment – and I hope for at least some, it will be uplifting and useful!

 

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Hong Kong – what is it good for?

Hong Kong is a city with a purpose. Always a hub of trade and a link between the markets of west and east, it now forms a key plank in China’s heroic efforts to get around economics. One of the many economic “laws” that china flouts is the impossible trinity –the notion that you can have two of the following three policies but not all at once: Free capital flows, control of monetary policy, and a fixed exchange rate. We have real world examples of the trinity’s inexorable logic to work from. The united kingdom when joining the ERM attempted free capital flows and a fixed exchange rate with the deutschemark, but an unwillingness to follow Germany’s tight monetary policy forced it to abandon the fixed exchange rate. Closer to home for me, the Asian financial crisis in the 90’s arose from large capital flows, fixed exchange rates and tighter monetary policies than the west. Fixed exchange rates gave the impression of low risk – and investors piled in – only to pile back out when Thailand were unable to defend their FX peg in response to capital outflows. The world changed in response. Those willing to give up control of exchange rates enjoyed monetary independence and free flowing capital – such as the UK. Europe formed a currency union effectively fixing exchange rates, but gave up control of monetary policy as the price of exchange rate stability. Asian economies either stagnated or pursued a mercantilist set of policies to build unassailable foreign exchange reserves, whilst keeping capital flows under wraps.

Now however the brutal logic of the marketplace is being supplanted, in part, by the even more brutal logic of total political control. China, having pursued Asian mercantilism par excellence, are now seeking to push a command economy style solution to the impossible trinity. The exchange rate “floats” but under the watchful eye of the PBOC. Capital controls are in place but are porous. Monetary policy actively manages liquidity and credit in every part of the system. The impossible trinity is only impossible because of free markets. Remove free markets and the rules no longer apply. Hong Kong is a crucial piece of that puzzle. China wants and needs access to capital markets on its own terms. Hong Kong is where it happens. With a fixed exchange rate, NO monetary policy (well, no official one) and a highly credible fixed exchange rate to the USD, it’s the perfect intermediary between China’s command economy and the international capital markets. This allows china the benefits of free capital flows without the cost of having to give up control of either monetary policy or its exchange rate mechanism.

However there is a cost. A normal economy has a stock of capital which maps onto a stock of financial capital (ie the money supply) because generally, in a capitalist economy, you need to borrow some money to get a project going. Borrowing creates money, investing creates real wealth. So the size of your economy relates to the amount of money. You can gin up the money supply a bit by lending more to consumers or to purchase financial assets, but there are risks to that, financial assets and consumption don’t create new cashflows to pay back the loans – so you end up with defaults. Hong Kong however has another issue. It’s money supply has to be sufficient to handle the capital flows between China and the western financial markets. However you measure China’s GDP, it is orders of magnitude bigger. This week, HKD interest rates have been spiking due to an IPO by “Ping An Healthcare” – a technology company intermediating between doctors and patients in China. Ping An is raising a total of $1.1bio USD. For the HK economy, that’s an enormous amount. The retail portion of this is 300x oversubscribed, and brokerages must find enough liquidity to cover all of these orders. These IPO’s happen with some regularity. So the HK economy has to have a money supply far bigger than it needs most of the time. That money is free to go around causing problems. Most obviously, HK property is absurdly expensive. Ditto any of the basic necessities of life that have any kind of rent component. Luxury, buying in imported brands is cheap enough, but space and land cost serious money.

And there are costs at the macro economy level also. Recently, the HKD traded right to the weak side of the 7.75/7.85 trading band vs the USD that the HK authorities maintain. This obliged the HKMA to spend USD to buy back HKD at the 7.85 level, and the market only stopped forcing them to do this when the IPO lockup period for Ping an was in sight. The reason HKD was trading so weak? Interest rates in the territory are over 1% lower than the US! Remember our impossible trinity? You’re not supposed to be able to have your own monetary policy with fixed exchange rates and free capital flows… and yet the territory needs vastly looser liquidity conditions than the US to do its financing job for China. So to buy this option back from the capital markets, the HKMA are forced to spend USD to maintain the value of their currency – whilst banks, hedge funds and retail all happily swap their HKD for USD or other higher yielding currencies and earn a low risk return. The HKMA is paying the private sector for the money supply it needs to keep the whole territory in business.

So how long can they keep doing this? Prior to the Fed beginning its hiking cycle, the pressure on the HKD was limited – and inflows to the territory would replenish the HKMA’s stocks of USD. Now that’s harder to imagine. Right now, the HKMA’s reserves are vast and cover the total size of the territory’s banks’ balance sheets several times over . So it’s a stable situation for now – but the direction of travel is clearly towards abandoning the peg or restricting capital flows. Years of mercantilism have given China, and HK, the firepower to pay their way around the impossible trinity for the time being – but as we saw before in the 90’s, what seems very solid can unravel exceptionally fast once confidence disappears – so I look forward to keeping you all informed about the state of play!

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HK Diaries part 4 – Singularity?

Buried in the sprawling, nightmarishly complex and totally pointless landslide of petty interference that is Mifid2 – there is a very interesting provision. I know, right – I was as surprised as you! Sitting in yet another interminable briefing on the topic, drawing spirals on my notepad, I suddenly heard this intriguing provision. From next year,  Algorithms involved in electronic market making must carry a unique identifier – and the trades they do will be reported to the regulator with that identifier attached.  This to me is absolutely momentous. For years, regulators and banks have effectively conspired to create a system of individual monitoring – individual bank employees now assume a huge amount of personal risk as they are responsible for upholding countless daft regulations, and what might be market practice one day is considered illegal the next. But this new provision effectively extends that kind of supervision of individuals to include individual algorithms. The next flash crash, at least in Europe where Mifid2 applied, will be analysed on the level of which individual bundles of code were trading, and presumably why. To me – the implication is clear. Algorithms are now being treated as participants in markets – not just tools that banks use.

When people talk about the “Singularity” in technology, they typically mean that some kind of AI will become intelligent enough to start creating and propagating other, even better AI’s, which is presumed to lead to some kind of either glorious utopia or terrifying robot world domination. But there’s a very crucial flaw in this scenario – namely the idea of “intelligence”. It’s very easy as human beings to go around using this concept, because we have a shared experience rooted in our biology of wanting certain outcomes, and so intelligence is  easily understood in terms of how we overcome obstacles to get those outcomes. For machines, there is no such goal/obstacle relationship. Of course, one can program an algorithm to contain a utility function, something to maximise or minimise depending on a set of constraints. It’s possible to imagine that at a sufficient level of complexity, these utility functions and algorithms maximising behaviour might lead to something that looks a bit like human intelligence. But that’s hardly the point. The algorithms already have a perfectly serviceable provider of obstacles and goals – us!

Seen like this, humans have largely been working in the service of algorithms for a lot longer than computers have been around. After all, a publicly listed company is a kind of algorithm – with a utility function (profits) to maximise, and a set of constraints imposed by law, physics etc. The humans who work for this algorithm provide it with a kind of mapping – interpreting the world into inputs that the algorithm understands. The humans here are giving the algorithm its goals, but the algorithm is providing the muscle to achieve them – sometimes literally in the case of a big company, sometimes computationally in the case of a modern trading algorithm – but the relationship between us and our technology is more complex now than that of tools. It is a two way street. Once a company or a trading algorithm starts, it becomes a part of creating the world that we live in. No human being ever decided that we should spend the majority of our time in offices, but the logic of the machines we created interact with our understanding of the world to make that decision for us. Computers like to be in air conditioned buildings. They like lots of humans in the same place to maximise network effects, and specialisation. In financial markets, they don’t like heterogeneity, and have no regard to the actual needs of investors. That’s why we have triple leveraged ETF’s on broad stock market indices, but no nominal GDP futures – the machines are configured to maximise profit, not fulfil the proper function of markets of allowing firms and households to reduce risk plan for the future.

In this context, the Mifid 2 insistence that Algorithms be identified, rather than firms, is quite radical stuff. But the substitution of firms for algorithms gives us a clue for how the AI alarmists could be very wrong. Ultimately, firms have nothing driving them but the goals set for them by people. Granted its  a two way street where people’s thinking can be driven by the conditions set by the firm they work for, but the willpower comes only from the people themselves. No matter how smart AI gets, and how much computational might it can muster, the involvement of human beings, with our single minded focus on  serving our own best interests, means that there’s no reason to expect machines to take over from us in the realm of setting goals in some sort of sudden revolution. Like public companies have affected the material conditions of the world, ever more advanced computers are doing the same – but its a gradual crawl as humans get used to being the thinking appendage of the systems we’ve built. Rather than a singularity, and an AI taking over the world, the machinery we’ve built is gradually assimilating us – as we become ever more inseparable.

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HK Diaries part 3: propaganda

Finance is widely considered to be a highly mathematical profession, indeed it’s the most common question I’m asked by people considering applying for a job in finance or wondering how I came to be involved. Well it’s certainly true that the day today grunt work of finance is highly mathematical – it’s essence for me is the stories we tell ourselves about what constitutes value, about what other people want, and about how people conduct themselves in exchange. If that sounds awfully high-minded to you and you consider your role within finance to be a simple numbers game then to be honest I don’t think you’re doing it right. Great traders, fund managers and market commentators understand the power of narratives as well as being able to crunch the numbers.

I certainly don’t consider myself great in any sense, but being a humble student of the market I take a lot of interest in the construction of narratives and their propagation. I often like to say that though many people believe a great many intelligent things and have much original thought, it’s often the stupid and naive thoughts that we all carry around with us that have the power to really move markets. An intelligent or nuanced idea typically struggles to make it far past the mind of its originator – but catchy if daft ideas can spread far and wide. Given that finance is a game of second guessing, an idea does not even have to be believed for it to have an impact, so long is enough people believe that it is important in the minds of others it can and will drive price action. One elegant expression of this is the aphorism the technical analysis works because technical analysis works!

Because I have not yet moved into my new flat and am languishing a serviced apartment with a TV hooked up to cable news, I’ve been taking the opportunity, to catch up on the kind of viral ideas that are spreading outside of the financial world. Propaganda is distinct from the viral ideas that spread in markets, in the sense that it is deliberately contrived with clear objectives in mind. This can happen in markets too, but too many people are on the lookout for it to be frequently successful. A propagandist deliberately sets out to create content that influences the Minds of others in ways they feel they can predict. Watching clearly partisan news channels such as Russia Today it seems like a strange hybrid is springing up. Whilst the institution of Russia Today very clearly exists to further the interests of Russia’s kleptocracy, it’s very clear that many of those contributing content do not share that objective. It’s a very strange spectacle to observe supposedly free thinking people being drafted into serve an obviously political end. I remember when I was a teenager frequenting various forums discussing religion and politics, it would often be said the trying to co-ordinate Internet users was like herding cats. Somehow contemporary Russian propagandist seem to have solved this problem.

During the Cold War, American counter spies were baffled by Soviet agents Who, in the wake of the Kennedy assassination, variously claim that Harvey Lee Oswald was and was not a KGB agent or a lone wolf. American intelligence agents who believed Soviet defectors who told them that he was acting alone were suddenly subject to suspicion because of rampant paranoia about Soviet infiltration of the secret services, so despite the unimportance of his motivations, enormous amount of manpower  were devoted to wrangling over them. This tactic of sowing confusion and doubt, and taking advantage of their enemies otherwise advantageous belief that they should be circumspect about intelligence they received has obvious parallels in the way that modern Russian propaganda merely seeks to sow division and doubt rather than to push a particular agenda. Of course it does do that too in another ways, but the principal purpose is to change the rules of the game of common knowledge from one where it’s possible to know the truth the one where truth is a relative concept, dependent simply on power. It’s obvious to see why a state whose advantages, such as they are, lie in tight hierarchical control and military aggression would benefit from pushing this view of the world.

However if we’re talking about who has managed to set up the best self-propagating and self-sustaining propaganda operation, recent Russian efforts are quite pathetic compared to what has been achieved by the Western media. Despite its focus, it’s difficult to imagine how the limited resources of Russian propagandists will ever compare to Hollywood and the Western press. Russia Today’s commentators are proud of being called useful idiots by the Western media, and I have some sympathy with that. At least they appear to be having fun and are able to put across their controversial opinions and compared to the hand ringing moral certitude and piety of many Western commentators they must feel they have it pretty good. Of course the fact that their number include George Galloway and Nigel Farage mean that the Western characterization is pretty much bang on. Still, the Hollywood actors whose movies promote American values around the world and journalists at The Economist who promote a highly America centric pseudo internationalism can probably be characterised in similar ways. They may not be idiots, but unbeknownst to them, they are certainly useful. All this is to say that looking at the institutions that lie behind the ebb and flow of “news” is of course far more useful than the news itself – in the same way that in markets, understanding the course of the narrative is much better than trying to figure out which is correct.

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HK Diaries part 2 – leverage!

Hopefully there is some crossover between the people I know professionally, and the people reading this, such that some of you will have received my weekly email. For those that are interested this contains some broad brush thoughts about macro trading, and some much more specific thoughts about local rates markets in Asia, where the majority of my focus will be. If you’re more interested in that then these ramblings, please let me know and I’ll sign you up for. 

For those interest in the ramblings, I wanted to share a few thoughts this week on the problem of leverage. Not the normal problem people talk about, Ie being scared by there being too much of, but the thorny problem of what exactly people talking about when they’re worrying. The problem is that like many macroeconomic ideas, leverage as applied to whole economies takes a sensible and well-defined accounting concept and seeks to generalise it into a tool to understanding a whole system of economic actors. When talking about firms or individuals leverage is simple to compute and the consequences are simple to understand. You can objectively say that one firm or one person is more leveraged than another by comparing the ratio of their borrowings to their equity. When are  look at firms it can be a little complex to compute their equity, but fortunately for most complicated firms there exists a lively secondary market in their equity which enables us to say sensible things about which firm is going to be considered more leveraged than another.

However already there are difficulties here. We know that because of biases that prevail in financial markets, certain kinds of companies trade at higher valuations than others. This means that without private information, it’s difficult to compute objectively how relatively leveraged each company might be. But whatever difficulties there are in measuring the equity of firms, those difficulties and multiplied in every dimension by trying to measure the equity of an entire economy. In fact, in most discussions of leverage in economies people don’t even try, rather they seek to compute leverage as a ratio of debt to income. That’s not because it’s more correct to compute leverage as a ratio of debt to income rather than as a ratio of debt to equity, but simply because this is what is possible. No matter how hard they may try, no index fund yet conceived constitutes a representative slice of an economies assets!

This is of particular concern when it comes to discussions of leverage in China. Not so long ago, the Chinese central government was issuing edicts to its entire population on the subject of how many common pests each household should be responsible for eradicating. There were quotas for rats, flies, mosquitoes and aparrows- indeed we observed in eerie Echo of this campaign in more modern times with the nomenclature used in Xi Jinping’s campaign against corrupt officials. Although a very low and dubious utility, this did result in large provision of services by the population to the Central government. It can be said with certainty that these were not included in any sensible national accounting. Neither should they have been. This is a trivial example but the point generalises. In a command economy when much of the economic activity is not based around transactions, national income statistics that are based exclusively on transactions are likely to be a poor estimator of economic activity. 

There can be little doubt based on their actions and public pronouncements that the Chinese authorities recognise the efficiency of Markets as a mechanism to allocate resources, yet their can be equally little doubt that the phenomenon of those markets generating the kind of messy and unpredictable outcomes that we observe in capitalist economies is of great concern to  a technocratic and authoritarian government whose first principle is to retain control. Money markets are fast, agile and forward looking. Transaction and sunk costs are low, and absent regulation, barriers to entry are minimal. It should come as no surprise that money and debt markets have grown so rapidly in response to liberalisation. Indeed the forms the growth has taken, with burgeoning shadow banking and wealth management products, as well as highly questionable practices by corporates whose main business is not in the financial markets but whose use of inventory and access to cross border financing can look very bank like in nature, should come as no surprise given that the authorities are reluctant to permit financial innovation by banks. If it is physically possible to make a buck, someone will give it a go. However much of the economy, the real economy that is, remains subject to central planning and state control. You therefore have a transaction based financial market that exists to serve a mixed economy. Such a market composed as it is of transactions that can be measured, should look big by construction compared to economies where are the financial markets are not developed like much of the developing world, or economies both financial and real markets a highly developed and almost entirely based on transactions as in the West.

This is definitely not to say that China has no problem with leverage. Clearly some exceptionally dodgy things are going on. Bonds  did not sell off this week, despite the new two month Repo operation, in a vacuum, and whether you want to blame concerns about supposedly hawkish new members of the politburo, alarmism in the financial blogosphere about the inclusion of shadow banking assets in overall leverage calculations by the pboc, or just some unspecified and difficult to evidence cash call going on in the shadow banking sector – it’s clear that markets are easily spooked. At the same time, at least one major Chinese conglomerate, hainan airlines, is very clearly facing financial stress – taking a one-year dollar loan at rates of almost 9%, which in a yield starved world definitely seems an act of desperation. But there are more interesting points to be made here about the difficulties of a hybrid economy than banging on about how levered they are. Chinese conglomerates have been on a state-sanctioned foreign acquisition spree, taking advantage of extremely loose funding conditions and a lack of willing takers of loans. As financial conditions tighten, and non-performing assets need to be financed none the less, it’s likely that some of these conglomerates will run into problems – but equally likely that the authorities will do their utmost to prevent these problems from spilling over into the domestic economy. Whereas the Western conglomerate facing problems abroad might choose to cut jobs at home or decrease domestic investment, Chinese conglomerates as all major actors in the Chinese economy are stuffed with communist party members to prevent them taking actions that are in their interests but don’t align with policy goals even on the sly. 

Given my left wing leanings, if you’ve made it this far into the post, perhaps you think I’m engaging in romantic exceptionalism because I’m just so happy to see a communist country doing well. You’ll have to trust me this is not the case. I may not have the kind of reflexive Ill Will towards the Chinese Communist Party that most in financial markets have, but I’m no lover of authoritarian regimes regardless of what they call themselves. It’s always tempting to doomsay. It’s always tempting to be a seller of new highs. Witness the gnashing of teeth bitcoins rise this week. Understanding the underlying mechanisms for why things are the way they are is much more rewarding I hope you would agree!

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