Almost 20 years ago in Hong Kong, my mind was opened to what actually happens when financial markets unravel. I witnessed how panic spreads like a virus from market to market. It was 1997 and the Asian crisis, which had started as a small problem in Thailand, suddenly engulfed the entire region. By the time it was all over, Russia had defaulted, as did huge swathes of South Korean industry. Meanwhile, LTCM – the most feted investment fund in the US – imploded. In such a panic, markets that appeared strong become weak and traders who appeared to be superhuman, masters of the universe, are revealed to have feet of clay.
The very remote can become local too. So, for example, the crash in China may well affect Dublin’s commercial property market. I’ll explain this transmission mechanism later but for now let’s focus on the cause rather than the consequences of the Great fall of China. The culprit is always leverage or borrowing. Once people borrow to speculate, the move from greed to fear and from fear to greed is lightning quick. In leveraged financial markets, there are only three certainties: death, taxes and margin calls.
Margin calls are what happens when speculators use borrowed money to speculate. When things are going well, they can make ridiculous profits but if the assets bought with borrowed money fall in value, the speculator has to come up with cash to plug the gap.
In order to find cash, the speculator must sell “good” assets that other people are prepared to buy to cover losses on “bad” assets that no one is prepared to touch.
This is how initial sell-offs of overvalued markets become massive routs, with speculators panicking all over the place. It appears that this is what is happening in China right now.
The question is whether it will spread and whether it could touch Ireland. We could be at a very sensitive tipping point for the global economy, where contagion is possible. There are a number of reasons.
The first is that there is no obvious locomotive for global growth if China slows down. China, a $10trillion economy, has been dragging the world along for the past few years. This dynamic looks like it is petering out. So what will replace it, particularly as half of the 30 biggest emerging markets – countries that used to be growing strongly too – have seen their stock markets fall by 20pc?
The world is now looking to America for economic strength. But the US economy, a $16trillion engine, is finding it difficult to grow at a sustained 3pc even after five years of recovery and even though interest rates have been at zero for most of that period.
Thankfully, unemployment has fallen down to 5pc but wages are not growing strongly in the US because productivity – output per worker – is still low.
The flipside of low productivity is low investment. US companies are not investing in machines and instead are using their profits, selfishly, to buy their own shares. This bit of financial engineering pushes up share prices and makes rich people richer because, in general, rich people own shares and poor people don’t own shares.
Meanwhile, the average guy, who depends on wages for his income, sees his standard of living stagnate and therefore despite being in work he doesn’t feel confident to go out and spend.
Although spectacularly wealthy himself, Donald Trump appeals to this disgruntled average guy. He is translating this blue-collar anxiety, which used to be Bruce Springsteen’s soundtrack, into the marching song of Trump’s foot soldiers. So we are not just talking economics here; these financial developments are political.
The second reason to be fearful is that commodity markets are signalling deflation and low growth ahead rather than inflation and high growth. West Texas oil prices are below $40 a barrel. In addition, falling commodity prices are getting more acute as the dollar rises. This is because all these commodities are priced in dollars.
The world has got to figure out whether China is a brilliant long-term story experiencing some short-term hiccups or whether it is a shorter-term success about to embark on a longer-term decline blighted by huge problems such as terrible demographics. Or to put it another way, will China get old before it gets rich?
These are the sorts of questions that will occupy policy makers in the years ahead, but for now let’s look at the root cause of this week’s financial/economic/banking problem.
The root cause of all this is too much borrowing – as always.
Since the 2008 financial crisis, the world economy has been bathed in the soothing balm of cheap money. The central banks all over the world responded to the crisis by reducing interest rates and printing money. However, only those who were solvent could access this once-in-a- generation cheap money. Therefore, the rich got their hands on the means to get ever richer.
This cheap money drove up the price of all assets worldwide. In time this cheap, borrowed money found its way into the most blighted nooks and crannies of the world economy.
One of these dark places was the post-bust Dublin commercial property market. This twist is where the fall-out from the China slump may become very interesting for Irish people. The type of guys who bought up the Dublin commercial property market are very much the same types speculating on currencies, stocks and countries.
Nama has succeeded in selling Ireland to US private equity outfits, which are from the same gene pool as the hedge funds that are selling China. The new guys who own Ireland have only a short-term time horizon and their sell signal will have much more to do with the general mood of global financial markets than anything that happens in Ireland.
They may well look around at all these leveraged investments – Irish commercial property being one – and decide to sell. Then who will they sell to? Why Irish investors, who are the “natural” owners of Irish property. But what will happen? These Irish investors will borrow from Irish banks to buy Irish assets from the foreign short-term leveraged merchants.
And we will end up in the curious situation where a property bust that was caused by Irish investors borrowing too much from Irish banks to own Irish property ends up with Irish investors borrowing too much from Irish banks to own Irish property! The foreign investors will get out and sell to Irish speculators, who will buy at a premium the assets they sold at a discount and the broker will be Nama – an arm of the Irish State.
You couldn’t make it up.
As the old Chinese curse says: “May you live in interesting times”.