By John Richardson
GILLIAN Tett’s splendid book about the root causes of the global financial crisis, Fool’s Gold, talks about “silo thinking”. Regulators, politicians and supposed financial experts had deep expert knowledge in their chosen fields, but lacked the ability to stand back and connect the dots. This, of course, led them to miss all the warning signs.
We worry the same now applies to China and its commodities markets – from iron ore to petrochemicals.
Here is how we believe the mechanism will work:
- Mining companies have vastly expanded capacity on the grounds that demand from collateral trade is real demand. But it isn’t. Most of it is sitting in bonded warehouses, or just in ordinary warehouses with the duty paid being used as collateral for housing investment.
- What goes up together also comes down together. So as the government targets a decrease in property prices, the logic for collateral trade comes to an end.
- All of this metal etc. will hit the LME and the Chicago Mercantile Exchange, where leverage is already very high due to the belief that the Fed will never let markets collapse again.
- A tsunami of commodities will flood Western markets, to the amazement of the investment community who hadn’t realised the close linkage between the collateral trade and China’s housing bubble. These people will get margin calls each night and will either have to put in more cash or sell. Either way, we risk seeing a vicious circle developing, which will be impossible for the Fed to stop, short of closing markets.
- This wouldn’t be a major problem if financial markets weren’t already at record levels of leverage.
- At this point, because we know how financial crises develop, there will be the sudden discovery that one of the darlings of the market on the way up – China’s commodities demand- was actually a fraud, like WorldCom in dotcom times.
The chart above is worth pondering in this context. Does anyone really believe that thorough due diligence has been done all of the $1.2 trillion of foreign loans that have been extended to China in recent years? The answer is sadly, very probably, “yes”.