Tuesday, 28 July 2015

China Crashes 8.5%

Over the last few months, there has been concern as to whether financial markets could write off the €350 billion of Greek debt. In one single night, on Monday, those same financial markets wiped off $500 billion of the same paper wealth from the Shanghai Stock Market alone! Despite the fact, that the Chinese state for the last few weeks has prevented large shareholders from being able to sell shares, has stopped the short selling of shares, and has itself intervened in the market to buy shares, as well as cutting official interests rates, relaxing credit conditions further and so on, the index fell by 8.5%. In the last few weeks it has dropped by around 30%.

It is, in fact, another indication of the fact that financial markets have no relation to the real economy. The Chinese economy is slowing, but still growing at around 7% a year, or more than double the rate in the US. Similarly, the Chinese economy has slowed compared to its previous growth, and yet in the last year, the Shanghai Composite Index had risen by 130%. These huge movements in financial markets have nothing to do with the underlying performance of economies. Stock prices should theoretically move up or down in accordance with the perception of the potential for future profits. A share is a piece of paper giving the owner an entitlement to interest on the money-capital they have loaned. That interest takes the form of dividends, paid out of the company's profits. If companies are likely to make higher profits, they can pay higher dividends, and so share prices should rise, and vice versa.

However, the consequence of money printing by central banks, and particularly since the late 1980's, when central banks have intervened to inflate asset prices, whenever they declined, created an environment in which speculators came to believe that the prices of bonds, shares, and property could only ever go one way – up. As a result, speculators began to disregard the interest they could obtain on their investment, especially as that interest got smaller and smaller. Instead, their focus came to be solely on the potential to make huge, rapid capital gains. Why would you bother about a few percent of interest, if you could buy a bond, a share, or a house, whose nominal value rose by 20%, in a few months, and whose price, if it ever dropped, was quickly boosted again by central bank action. This was a vicious circle, because the rate of interest, the yield, on all of these financial assets gets smaller as the price of the asset gets higher. So, the lower the yield became, the more speculators became concerned instead with making capital gains, and the more they became interested in making capital gains, the more they pushed up asset prices, and thereby reduced yields.

But, this can only go on for so long. At a certain point such bubbles burst, and whereas it takes a long time to inflate bubbles, they burst violently and suddenly. But, as 2008 and other such financial crises demonstrate, when these bubbles begin to burst they create a chain reaction. As speculators lose money in one place, they have to scramble for liquidity by selling assets in other markets, and other classes, even where those other asset classes may still be very lucrative. That is particularly the case where speculators have gambled in these markets with borrowed money. Reports say that many of the people who speculated in the Chinese markets over the last year, have been ordinary people, who saw the market soaring by 100%, and borrowed up to $1 million to finance their speculation, thinking they would become overnight millionaires. Instead they have lost $300,000, as the market crashed, with no possibility of paying it back.

Its not as though, this is a zero sum game, where one person's loss on such a gamble is another person's gain. If I have a £1 million house, and so do you, we can delude ourselves that we have somehow become wealthier, if I sell my house to you for a nominal price of £2 million, and you sell your house to me for £2 million, but, in reality, nothing has changed. I have not gained £1 million of wealth, and nor have you. Similarly, the nominal prices of all these financial assets can be reduced by 90%, but 90% of that wealth is not thereby transferred into the pocket of someone else, it has just disappeared in smoke. The real benefit is rather to anyone who has money. That money then becomes much more valuable by comparison. If I have £100,000 in the bank, and house prices drop by 90%, my money becomes worth 10 times as much. My £100,000 will now buy me a £1 million house, and the same thing applies as far as the prices of bonds, shares and so on. It is not that a crash in prices magically transfers wealth into someone else's hands, but that it super powers money. That is why in times like this, smart investors have always sought to keep a lot of their wealth in liquid form, ready to snap up property, bonds, and shares, when their prices seriously crash.

By contrast, the amateur investors, and Joe Public are always drawn into the markets at such points to buy these overpriced assets, because that is the means by which the smart investors are able to offload their overpriced assets, raise liquidity, and thereby wait for the crash, so as to pick up huge bargains. Its the process I discussed recently.

But, this crash in Chinese markets is also an indication of the other factor I discussed recently, that the massive growth of this fictitious capital – property, bonds, shares - is actually detrimental to the accumulation of real productive capital. It sucks realised profits away from accumulation of capital, required for the further expansion of surplus value, and drags it into a meaningless spiral of speculation that creates huge paper wealth in the hands of a tiny few money lenders, whilst undermining real productive wealth. Once again that situation cannot continue. It leads as Andy Haldane of the Bank of England commented, in capital “eating itself.”

I have been pointing out for some time, that there has been a shift in the conjuncture of the global long wave cycle, from the Spring to Summer phase. It means that interest rates globally are now in a rising phase, because the demand for money-capital will rise relative to its supply. The consequence of rising interest rates is that the prices of fictitious capital in its various forms fall, because the yield on these assets is inversely related to their price, as set out above. That is what we are seeing. It represents a shift in power away from the fictitious capital, whose value will drop, and towards productive-capital.

Conservatism is based upon the former and social democracy on the latter. It is why we are seeing the attack on fictitious capital referred to. The first skirmish in this battle has been Greece. Part of this shift in conjuncture, also means that labour supplies begin to be used up, so that wages tend to rise, a phenomenon seen markedly in China and other Asian economies, but also being seen in the US and UK, now. That again strengthens social democracy vis a vis conservatism. There are a range of other factors that play into this process that I have referred to previously.

For example, I discussed a few weeks ago the consequence of the sharp falls in the oil price, which is itself a normal consequence of the long wave cycle, as the huge rise in investment and technology in the production of primary products, over the last 15 years, creates a large rise in the supply of those products, and with lower costs of production. But, the consequence of that is that some parts of this production become unprofitable, for example, in the North Sea, and some of the frackers.   This has already led to huge sell-offs in the junk bond market.  I discussed in those earlier posts the fact that a large proportion of the junk bond market was now accounted for solely by the energy sector, and that around 30% of these bonds were now effectively bad.

The renewed falls in commodity prices over the last week or so has seen these junk bond prices fall to even lower levels than when the oil price dropped earlier in the year, and consequently the yields on these bonds to rocket.  The junk bond market is notoriously illiquid, like the property market.  Any sell-off causes pronounced falls in prices, because its impossible to quickly find buyers at any price.  Moreover, as legendary bond investors like Bill Gross have said, a crash in junk bonds could quickly spread into the rest of the bond market.  With the continued debt crisis in Europe, in Costa Rica, and a whole swathe of large US cities, and with global private debt levels at astronomical levels, this is a ticking time bomb waiting to explode.

To the extent that previously these primary product producers were large contributors to state budgets, in the provision of taxes, those states have to fund their activities by alternative means, i.e. borrowing in the capital markets. This is another reason that the demand for loanable money-capital rises relative to the supply, and so pushes interest rates higher. The effect in respect of Norway has been marked, but Saudi Arabia, recently tapped the capital markets for $4 billion, the first time it has borrowed for more than 8 years. It is just one of a range of economies that have enjoyed massive revenues, which were pumped back into capital markets, as a supply of money-capital, which has now reversed, and become a drain on those capital markets.

China is being encouraged by the IMF to withdraw its attempts to prop up the country's financial markets, because they are unsustainable. The Chinese Authorities are obviously reluctant to do so, because millions of Chinese citizens will lose everything, and that is likely to create significant social unrest, but they seem to have little alternative. The reality is that its the problem of this fictitious capital writ large. Quite significant numbers of Chinese citizens, who previously would have put their savings into some small business, or farm production, instead used their money to gamble on the stock exchange. Instead of creating real wealth, and a potential for future earnings, they created nothing but a blizzard of worthless paper flying around the financial markets, and now that blizzard is being blown away.

But, it is not just China and Chinese citizens affected by this. Just as the drop in oil prices means that the oil sheikhs and the Texas oil barons have to borrow money, rather than lend it, so too a collapse in Chinese share prices, especially financed by borrowing, sends those investors scurrying after funds to cover their margin calls. It means they have to sell the London property they bought purely for speculation, for example, which is one reason, we have seen the prices of expensive property in Kensington and Chelsea drop by 7.5%, just in the last month. But, these Asian property syndicates have been buying property across Britain, which, along with laundered money from international criminal gangs, is one of the reasons property prices have been pushed up in some places, and failed to drop as much as they should in others.

Economic activity has been relatively subdued since the third quarter of last year, because of the three year cycle, but a new up turn in that cycle is due in the next quarter. In fact, UK GDP for the second quarter of 2015, has come in at 0.7%.  Increased growth in the US, in the EU, and UK will cause the already apparent shortages in some sectors for labour and some inputs (despite the low level of construction in the UK there is already a shortage both of bricks and bricklayers, for example) to lend added impetus to the already rising level of wages. Increased consumption will lead firms to advance additional capital for materials and labour-power, if not initially in fixed capital spending. Not only does that thereby pressure the rate of profit, but it increases the demand for money-capital, relative to its supply, pushing interest rates higher once more. In addition, these shortages, at a time of oceans of liquidity swilling around economies, creates the conditions for a sharp rise in consumer price inflation that central banks are currently ill-prepared to cope with.

It takes two years for monetary policy to slow inflation, and they are well behind the curve to deal with it, if wages and prices begin to spiral higher in the coming weeks and months. That will mean that bond markets will sell off sharply, as bond investors demand much higher yields to compensate for losses due to inflation.

In my firstbook, I described this kind of situation, as the backdrop to the next financial crisis. China, as I set out, is very similar to Britain in the 19th century. It is in periods like this that crises of overproduction are more likely, as production is rapidly increased ahead of the potential of markets to cope with it. It is in periods of stagnation (Winter Phase) when rather than crises of overproduction, production grows slowly, that prolonged periods of unemployment and under utilisation of capacity manifest themselves. As I set out in my book, China is a classic example of where such a crisis of overproduction could break out. The fact that its authorities have fuelled asset price bubbles, rather than using their levers of control to develop sufficiently their own domestic market, their own welfare state, and so on, could make that more likely.

But, the basis of the current crisis, for now, resides not in the economy, but in these financial markets. In fact, a new financial crisis to clear out this fictitious capital is a precondition for establishing economic growth on a more sustainable basis. That is another reason that the attack on that fictitious capital has begun.

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