• China’s financial system is becoming increasingly complicated and confused (not to mention confusing), and this is most likely a consequence of a contraction of PBoC reserves (after two decades of expansion) and what we can only assume is a rising amount of unrecognized bad debt, which ties up liquidity. This combination puts significant liquidity pressure on the banking system.
• Banks are responding with a complex mix of financial engineering and speculative lending, creating an illusion of liquidity. Retail and institutional investors, meanwhile, rotate from one market to another, driving bubbles as they move.
• As concerns about excessive debt continue to rise, as they have all year, we are starting to see a sharp reversal of last year’s near-collapse in credit spreads. Investors should be very aware that while collapse of credit spreads increased underlying liquidity, its reversal is likely to have the opposite impact.
• Over the last three years we’ve seen a series of unexpected disruptions in different sectors of the financial system. With so many moving parts it is impossible to predict where and when the next one will happen, but it is safe to assume that these financial disruptions will recur regularly over the next few years, and probably at a faster pace than in the past.
• The first two stages of the global financial crisis, the US in 2008 and Europe in 2009, were caused by global demand imbalances brought about in part by distortions in monetary policy, and in the third stage, China’s adjustment will trigger an emerging market crisis. The response among major central banks is aimed at boosting demand in the short term, but may very well weaken demand in the longer term by exacerbating income inequality.
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