World asleep as China tightens deflationary vice

China’s Xi Jinping has cast the die. After weighing up the unappetising choice before him for a year, he has picked the lesser of two poisons.

The balance of evidence is that most powerful Chinese leader since Mao Zedong aims to prick China’s $24 trillion credit bubble early in his 10-year term, rather than putting off the day of reckoning for yet another cycle.

This may be well-advised for China, but the rest of the world seems remarkably nonchalant over the implications. Brazil, Russia, South Africa, and the commodity bloc are already in the cross-hairs.

“China is getting serious about deleveraging,” says Patrick Legland and Wei Yao from Societe Generale. “It is difficult to gently deflate a bubble. There is a very real possibility that this slow deflation may get out of control and lead to a hard landing.”

Zhang Yichen from CITIC Capital said the denouement will be a ratchet effect since China has capital controls and banks are an arm of the state, but that does not make it benign. “They are trying to deleverage without blowing the whole thing up. The US couldn’t contain Lehman contagion, but in China all contracts can be renegotiated, so it is very hard to have a domino effect. We’ll see a slow deflating of the bubble ,” he said.

What is clear is that we are dealing with a credit expansion of unprecedented scale, equal in size to the US and Japanese banking systems combined. The outcome may matter more for the world than anything that the US Federal Reserve does over coming months under Janet Yellen, well signalled in any case.

The Fed’s Janet Yellen can hardly back away from bond tapering as her first order of business, even though US data has turned soggy. She has to shake off her (unmerited) reputation as a dove. Besides, most Fed governors are on the warpath against asset bubbles.

They may be right, but bear in mind that the growth rate of America’s M2 money supply has halved over the last year. It might have contracted since April without $85bn of bond purchases by the Fed each month.

The European Central Bank is paralysed after the German constitutional court read the riot act last Friday, strongly suggesting that its bond rescue plan (OMT) is Ultra Vires and a violation of “monetary financing”.

The ECB cannot easily carry out quantitative easing to cushion a deflationary shock in the teeth of such a judgment, even if QE is a different tool. In German politics they are the same.

So we keep our fingers crossed as we glimpse the first foam of a deflationary Ch’ient’ang’kian coming our way from China. The world’s central banks have no margin for error.

Full article: World asleep as China tightens deflationary vice (The Telegraph)

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