Systemic Risk

July 21, 2020

Today marked new market highs for US stocks, and the constant whine coming from this blog is probably annoying, grating on nerves perhaps, but it isn’t without evidence. There is a lot wrong, certainly a lot more than there was back in February when the market was this high, but you wouldn’t know it based on asset prices.

While preparing a bunch of work to post about GDP and the horrible GDP number that will be published next week (the GDPNow indicator is currently suggesting a decline in Q2 GDP of -34.7% year over year), I ran across a more interesting story about the kinds of systemic risk that you probably never (ever) consider. (You don’t consider it because you have friends and go to gatherings and discuss sports, beer, weather, the latest movies, etc. This is not a topic to bring up over dinner or at a party, ever!)

Systemic risk is a big deal, because it can alter an entire system. In the Great Recession, when housing collapsed, Lehman brothers was the ‘final straw’ that made the whole housing finance system break. The entire system was thrown into disarray with banks collapsing, home prices collapsing, jobs being lost . . . you may remember it. The systemic risk at the time was too many mortgages to too many people who couldn’t pay the money back. This small oversight was replicated by many banks, but it only took one participant who failed to bring down the entire ecosystem of mortgage lending.

You could generalize that risk as ‘bad stuff happens when the money runs out’. It has been mentioned on this blog a LOT. Well, this time, someone else’s work is going to take centre stage.

On Monday evening Anjani Trivedi and Shuli Ren published an article on Bloomberg about China getting closer to a Lehman moment. In essence, insurers in China have been selling policies with promises of really high returns for many years. In the past few years, some of those providers haven’t been able to make good on their promises.

Needless to say, some of the policy holders are a little bit upset and the government of China has had to step in . . . more than once. The article details how this has now grown to a significant problem and it is made worse by COVID-19, when returns have declined. It may become a systemic problem.

The outcome of these problems is that people who would normally wait for their money based on a contract, find out that the contract really isn’t worth the paper it’s written on. (Think Bernie Madoff, or pensions that were decimated or worse during the Great Recession. If you don’t remember these things, it was bad. Really bad.)

When the problems start, often depositors and/or investors try to get their money back (if it is a bank, it causes a ‘run on the bank’) and when they can’t they often cause social and political unrest (see Venezuela, Greece and Cypress for recent examples.)

The problem sometimes seems small at first, but the difficulties spread to the entire financial system, the entire economy and frequently they cascade to other areas such as jobs, food, shelter. It affects the entire system.

To be sure some really big hedge funds have been betting on the Chinese system to be brought to it’s knees for a long time because of overbuilt housing, because of excessive lending, and inconsistent (some say questionable) economic readings. It hasn’t happened. It may not happen now either, but there is trouble brewing.

China is now the largest economy in the world by some reckoning, and if it slows down, or worse has a dire need for capital, then one of the largest providers of capital in the world will no longer be a reliable funding partner for the many projects, supported by China, that create growth around the world.

Worse than that, the significant amounts of debt financed by China around the world in the past two decades may have strings attached, putting pressure on the borrowers to repay early, slow projects or even interfere in local politics. There are a lot of larger risks in this scenario, none of them yet proven.

Currently there is a potential for a systemic financial problem in China, but there has been one for a long time. This time it’s a bigger problem than it was before, and maybe things will get worse, or maybe the Chinese authorities will be able to cover it up yet again.

The real concern is that these problematic events keep popping up. All over the place. More frequently than government can defuse them. When the next Lehman moment arrives (the one AFTER COVID-19), the flexibility of governments to respond will be almost non-existent.

High debts and an under-employed population are significant risks for any economy. A systemic risk will exacerbate these issues and cause a reset of many factors in an economy/society. Asset prices are one of the first things that get reset. Be careful.

Addendum: [July 21, 2020]

It only took one day for the reality of this post to start hitting the wires. Not the China systemic crisis, rather the knock on effects from governments running out of money. Apparently the Government of Ghana has $1.5 billion in arrears to its ‘independent’ power sector and they are threatening to shut off the power if they are not paid ‘with immediate effect’. You won’t be surprised to find out that some of those independent providers have Chinese partners (as well as partners from Europe and America). The point remains that when the money runs out things can go bad and that is likely the direction for those in Ghana who need electricity.

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