The Chinese Inflation Monster stalking the world

By Filipe R. Costa

While a lot of attention is focussed on America’s Quantitative Easing programme, there is another side of this story, developing on the other side of the balance sheet, on the other side of the world. This concerns the pace of asset creation on banks’ balance sheet.

In America bank assets have grown by $2trillion since September 2008. This might sound like a lot, but consider in this time that the Federal Reserve has pumped $2.5trillion into the banking system. In other words US banks have delivered to the tune of $500billion over five years. However, in China the story is very, very different. Over the same period, Chinese banks have increased their assets by $15.5trillion!

This staggering figure could well prove to be the catalyst that sparks an inflationary boom. After all, what will happen with this money (and this is real money, not bank reserves)? It is out there and it is inconceivable that it will simply stay on banks’ balance sheets, collecting the financial equivalent of cobwebs.

Perhaps things will be different in centrally controlled China, but the temptation for bank executives will surely be to lend against these assets, to fuel further China’s real estate boom (cough, bubble, cough!).

The next big question about this accumulation of “wealth” concerns what happens when central banks finally wind down the printing presses?

With the Fed injecting $1trillion of liquidity into the financial system and the People’s Bank of China (PBOC) estimated to be adding a further $3.6trillion annually (and yes that is not a typo), this totals $4.6trillion. This is also not to mention the $700billion a year added by the Japanese, nor does it account for a likely European action in 2014. The numbers are almost too large to comprehend and it is nearly impossible to see how these programmes can be unwound in an orderly manner. In the last 6 months, markets declined substantially at the prospect of Fed tapering a “meagre” $0.25trillion a year and when the PBOC was rumoured to be about to tighten by about $150billion the overnight Repo rate exploded 25%.

This just shows how tentative the situation truly is.

Just imagine the chaos if the >$5trillion annual stimulus was cut at once!

So, if monetary tightening would result in another financial crisis and a very harsh recession, let’s consider what might happen if the current trend is continued. Chinese banks have a total of $24trillion of assets on their books, which correspond to 2.5x their country’s GDP. To please shareholders and deliver profits they need to put these assets to work. To do so, their choices are limited to the traditional targets for investment i.e. assets in the real world. In the past, excess capital in China was put to work in the American property market. This helped push prices into bubble territory and was a contributing factor to the collapse in 2007. As is ever the case with such events, the lessons have not been learned. Cash rich Chinese banks are the monster stalking global asset classes. If allowed free rein expect prices across the board to go high, much higher.