I recently read this excellent article from the FT. In regard to our dialogue today, this is the important part:
“The free movement of capital will lead to an optimal allocation of resources and the integration of open, competitive and efficient European financial markets and services. It will also help maintain “responsible” macro-economic policy and can foster growth through finance and knowledge transfers (direct investment).”
“There is now a growing recognition that the short term nature and inherent volatility of global capital flows are problematic.”
Surely, only one of these statements must be correct… right?
What is a cycle?
Credit moves in cycles. Let’s start with some simple examples.
Between 1500 and 1800, France abrogated it’s debt eight times. During this time French monarchs had a habit of executing major domestic creditors. Creditors lent money to the French crown, and when favorable conditions changed debt was forgiven. In the beginning money is lent. In the end debt is forgiven and a head is lost.
This is not an extreme example. The US occupation of Haiti beginning in 1915 was rationalized as necessary to collect debt.
Why do we have these cycles?
Why did domestic creditors issue money to the French crown if they risked losing their head? The same reason that people would trust Mozambique to repay a $850 million tuna bond. In finance or economics we refer to this as ‘searching for yields,’ and leftists often refer to this as ‘greed.’
This is nothing new. Between 1822-1825, Latin American states raised more than 20 million pounds. London, in a search for higher yields, caught silver fever.
This increase in credit leads to increases in debt. If history is any indication, the increase in debt often proves to be unstable, and countries are forced to restructure their debt. From 1826- 1828 Buenos Aires, Chile, Greater Columbia, and Peru defaulted on their external debt. London’s silver fever was for naught.
If you would like to know more about the history of debt and credit cycles I highly recommend This Time is Different, which I am paraphrasing in today’s post.
Friction in the world’s cycle
The opening quotes from the European Commission and Christine Lagarde are not mutually exclusive. Instead, they provide the dominant ideology at their point in the credit cycle. So Ms. Lagarde’s comments highlight the prevailing mood of the world: there is great political fragility in our current version of globalization.
This political fragility comes in many forms: reassertion of national identities as a response to global immigration, rejection of centrist political parties, and general distrust of federal and international institutions. In the same way that the European Union refuses to acknowledge its immigration woes, fighting a cycle causing enough distrust to cause Britain to leave the EU, China is refusing to admit its unsustainable reliance on increasing rapid credit growth and debt. China is fighting the credit cycle.
The same cycle that is showing political fragility in the rise of Donald Trump is causing large capital outflows in China. High debt levels can adversely affect growth any time there is uncertainty about how debt servicing costs will be paid. Intelligent actors will do what is necessary to protect themselves and their assets from bearing the costs of debt. This is happening now.
Money is leaving China, and what it wants is safety and security. Pre-communist China defaulted in 1921 and 1939 on its external debt. It then relied on domestic debt to fund its political needs; domestic debt grew exponentially. Although China was able to fight the cycle in order to fight the Japanese, someone is going to pay that money. Someone, just like the French creditors pre 1800, is going to lose money and maybe a head.
The most well connected and wealthy in China are not stupid. They want to move their capital before the cycle leaves their wealth exposed. Any company not prepared to accept this new environment won’t survive the changing cycle.