The China Dream

This post draws significantly on Edward Chancellor's white paper "China's Red Flags"

Past manias and financial crises have shared many characteristics. Below is a list of "leading indicators" of financial distress.

1. Compelling Growth Story - usually associated with some new technology or exciting prospects for a particular economy.

2. Faith in the competence of authorities -examples include the Fed in 1920s and the "Greenspan put".

3. A general increase in investment - capital is mis-pent during periods of euphoria. J.S. Mills said "panics do not destroy capital, the merely reveal the extent to which it has been previously destroyed by its betrayal in hopelessly unproductive works."

4. Surge in corrpution

5. Easy Money - Low rates lead investors to chase higher yields and riskier assets. Bagehot said "John Bull can stand many things, but he cannot stand two percent"

6. Fixed currency regimes - which generally lead to too low rates and large capital inflows. The EMU lead to property and consumption booms. Asian crisis of 1997 is similar.

7. Rampant Credit Growth - liabilities are contracted that cannot be repaid (NPV of a project cash flows is less than the stock of debt). Sharp deviations of credit growth from past trends and lagging credit growth tends to be a leading indicator of financial distress.

8. Moral hazard - the belief that authorities won't let bad things happen. Irresponsibility is not punished.

9. Financial Structures Become Precarious - Investments do not generate enough income to finance the loans (Ponzi Scheme). As a result, the market becomes vulnerable to what otherwise might be considered insignificant events.

10. Dodgy loans are securitized by collateral. Real Estate busts are generally worse because they are associated with real economic activity (construction).