A Quadrillion Dollars Used To Be A Lot of Money

Can the SVB debacle unravel the derivatives house of cards?

A version of this article appeared in Beijing Review magazine.

On Friday March 10th, Silicon Valley Bank (SVB), the 16th largest bank in the United States, became the second largest banking bankruptcy in US history. This was the third bank to collapse in week following New Republic and the crypto-focused Silvergate. In the wake of the announcements President Biden was quick to reassure depositors that the Federal Deposit Insurance Corporation (FDIC) would cover all deposits irrespective of the FDIC USD $250,000 ceiling.

The collapse of SVB is already creating ripples across the world. Bloomberg reported recently that Sweden’s largest private pension provider has a potential USD $2bn in exposure to banks linked to SVB and Forbes reported hundreds of Indian tech start-ups have been affected, to name but two. Added to this, there is reason to believe the crisis could become more serious than the 2007-9 financial crisis.

The first reason is the nature of the crisis. While the financial crisis of 2007-8 was caused by widespread corruption linked to the derivatives market for repackaged sub-prime mortgages that had been fraudulently valued the current crisis is systemic and was caused by overinvestment in Government issued debt or Treasury Bonds.

COVID-pandemic related measures in the US created a vast transfer of wealth upward in the US economy and this transfer materialised as huge deposits in the banking sector that banks invested in treasury bonds in order to profit from arbitrage. At the time, banks were paying around 0.2 percent interest on short-term deposits and were able to make upwards of 2 percent on treasury bonds.

However, this vast transfer of wealth, combined with the supply chain disruptions caused by the COVID-pandemic and compounded by anti-Russia sanctions related to the conflict in Ukraine fuelled inflation across the West leading to wage rise demands that potentially threatened corporate profits and correspondingly stock prices.

In order to stop these wage demands and protect asset prices in the financial sector the Fed decided to increase unemployment by 2 million by raising interest rates. However, to do this the Fed had to issue new bonds at a higher rate of interest thereby reducing the value of the bonds held by the banking sector. This meant that the bonds held by the banks were no longer worth what the banks had paid for them.

Essentially this is a paper loss and everything would have been fine so long as no one needed their money in the next ten years. The problem came when depositor decided to move their deposits to money management funds based on the newly issued bonds that offered a much higher rate of interest. To cover these withdrawals the bank was forced to sell its treasuries and realise the losses on its balance sheet making it incapable of covering the deposits.

So, the question is: How big is the problem? Well, according to the FDIC, unrealized losses on investment securities across the banking sector are currently running at around USD $680bn. Although, this is not a small amount of money, it is relatively small compared to the totality of the derivative debacle of 2007-9 when the Fed bailout the banking sector to the tune of USD $700bn in taxpayer’s money and a subsequent USD $40 trillion in quantitative easing (QE) over the next 13 years.

President Biden, Treasury Secretary Yellen and Chairman of the Federal Reserve Powell were quick to try to calm markets. Biden announced the FDIC would cover all deposits even those over and above the legally mandated USD $250,000; Powell announced the collapse would not alter the Fed’s interest rate policy before quickly back-pedalling under pressure from the financial sector; and Yellen announced that the Fed would open a discount window allowing banks to borrow against the book value of their now underwater treasury investments.

This creates two immediate problems for the Fed. By guaranteeing deposits in banks deemed too important to fail they are potentially opening the door for runs on banks that are not too big to fail and by allowing banks to borrow against the book value of their assets – not the market value – they are potentially on the hook for USD $620bn.

It also means the Obama-era policy of quantitative easing has painted the Fed into a corner. In essence, QE has inflated asset prices – stocks, bonds and real estate – so much that any attempt to cool the economy and address inflation will have significantly negative consequences for the financial markets. It also can’t lower interest rates to reinflate asset prices without stoking inflation.

In essence, the Obama policy kicked the financial can down the road without addressing any of significant structural problems it illustrated. The most significant of these structural problems is the derivatives market which has ballooned since 2007.

Derivatives are basically bets on what will happen in the market and were first invented to help the agricultural sector hedge against unexpected changes in the price of inputs or outputs but grew massively in the era of near-zero interest rates when anyone could borrow money to go to the races.

When Warren Buffet famously labelled derivatives “financial weapons of mass destruction” in 2002 the ‘notional value’ – the value of the assets underlying the bets – of the derivatives market was estimated at USD $56 trillion. However, the Bank for International Settlements (BIS) estimated the notional value of the derivatives market was USD $610 trillion at the end of June 2021. BIS estimate that figure could now be close to one quadrillion, many time larger than global GDP, but the real figure is hard to know because most of these trades are done privately.

Derivatives add a layer of financial risk to the economy because the market is so interconnected that failure by a counterparty can quickly have a domino effect and most of the banks involved are too big to fail.

According to Ellen Brown, founder of the Public Banking Institute; “[Derivatives] are sold as insurance against risk, which is passed off to the counterparty to the bet. But the risk is still there, and if the counterparty can’t pay, both parties lose. In “systemically important” situations, the government winds up footing the bill.”

As of the third quarter 2022, the federal bank regulator, the Office of the Comptroller of the Currency, over 1000 federally insured financial institutions held derivatives but over 88 percent were held by five large banks: J.P. Morgan Chase ($54.3 trillion), Goldman Sachs ($51 trillion), Citibank ($46 trillion), Bank of America ($21.6 trillion), and Wells Fargo ($12.2 trillion). Increasingly it looks like Credit Suisse might have been the first domino to fall.

Worryingly, many of the bets in this market relate to interest rates which are now rising. Additionally, most of these bets are placed on assets upon which the purchaser has no underlying interest. As Brown points out, “If you don’t own the barn on which you are betting, the temptation is there to burn down the barn to get the insurance.”





Beijing Ponders Rent Controls and Regulation

The government in Beijing is eyeing plans to introduce rent controls and regulate the fees realty agents can charge-no doubt welcome news for many residents trapped in an overheating housing market.

Authorities in Beijing are currently considering the possibility of new rules for housing rentals that would limit rent increases and set guidelines limiting rents and agent fees

The Beijing Municipal Commission of Housing and Urban-Rural Development’s proposed scheme contends that current legal structures do not meet the current needs of new rental models, such as rental loans and long-term apartment leases. Under the new proposal the housing commission will monitor rent increases and could be given powers to limit increases, investigate and punish rent gouging.

If the draft legislation passes, Beijing will be China’s second city to introduce such measures after Shenzhen enacted similar legislation earlier this year.

Under the new proposals landlords will be restricted to collecting rent monthly and deposits will be limited to one month’s rent. At present in Beijing typically landlords demand three month’s rent in advance plus a month’s rent deposit; however six month’s rent is not unheard of.

Following the collapse of Danke, one of China’s largest online apartment rental platforms last year, regulators have been keeping a close eye on the rental market and the debt fuelled growth in the sector.

Danke, and its competitors, business model was to rent apartments from landlords on long-term contracts then sublet them tenants. The pandemic driven financial collapse of Danke resulted in the eviction of thousands of tenants even though rent had been paid in advance.

Beijing Takes Collection of Land Sales Income Out of Local Government Hands

The central government is aiming to change the way in which revenue from land sales is collected and monopolize it in Beijing’s hands, as part of the country’s efforts to crack down on what Beijing sees as profligate spending by local authorities using the money they make from land use rights according to Caixin.

Under the new system local governments will transfer the right to collect land sales revenue from their natural resources departments to tax authorities overseen by the State Taxation Administration (STA), according to a recent decree issued by the central government. One city and six provincial-level regions have already joined a pilot program paving the way for national roll-out on January 1, according to the notice.
The reforms are part a plan issued in early 2018 that tax authorities should extend their remit to collecting nontax revenue under in a bid to make collections more efficient and better regulated.

The proposed overhaul of which government departments will collect the more than 8 trillion yuan of land sales revenue will help the central government keep better track of the money and help stop local governments from shoring up their financing vehicles with the funds, as tax authorities ultimately answer to the central government’s State Tax Administration.

Beijing has been working hard to control local government debt for years, mostly hidden off-balance-sheet in local government financing vehicles (LGFVs), companies set up specifically to borrow the money needed to fund spending on public welfare projects and infrastructure, which generally bring in low returns. This situation arose when Beijing banned local governments from issuing bonds to borrow directly.

For more on this and how LGFVs work read this article on China’s shadow banking sector and local debt.

The new measures are an attempt to plug the loopholes where local governments illegally return part of land transfer revenue to LGFVs participating in land auctions, or allow them to reduce or delay payments. Under the new system, local governments will find it more difficult to use land transfer revenue for their own purposes forcing them to be more compliant in terms of using the money.

However the new measures could significantly affect the ability of LGFVs ability to repay debt already owed to local governments and private investors.

Xinjiang – Gateway to the World?

A version of this article originally appeared in Beijing Review.

Photo: Ryan Perkins
Horgas Dry Port

Xinjiang, an autonomous region in northwest China, is home to vast deserts and mountains and many ethnic minority groups. The ancient Silk Road trade route linking China and the Middle East once passed through Xinjiang, and its legacy can still be seen everywhere. The dry port Horgas is breathing new life into this ancient trade route.

Horgas, once a sleepy backwater straddling the border of Xinjiang’s Ili Kazakh Autonomous Prefecture and Kazakhstan has been transformed as a key part of China’s Belt and Road Initiative. Its strategic position has turned the city into the one of the largest dry ports in the world and the starting point for the China-Europe railway. And the demand is growing.

Thanks to the dry port, trains and trucks can carry goods from eastern China to Western Europe in around two weeks, compared to a several week journey by container ship or vastly expensive air freight.

As economies around the world reeled from COVID related countermeasures, demand for made in China products soared. China posted a huge $535 billion trade surplus in 2020 according to the AP; a 3.6 percent increase in exports over 2019 to a total of $2.6 trillion; and a subsequent 1.1 percent reduction in imports. At the same time China overtook the US to become the EU’s top trading partner in goods, according to Eurostat data.

Photo: Ryan Perkins

As a result of the asymmetry of global trade, shipping rates reached a 12 year high at the end of last year. Containers continued to flow out of China’s ports but the imbalance of trade with COVID affected countries meant that the containers simply were not returning in the same volume. This led to a sudden spike in freight rates and increased shipping delays. All this made the rail freight option very attractive in 2020.

At Horgas itself, three giant rail-mounted gantries rise from the desert and meticulously move up and down the lengths of freight trains arriving from China and load them onto trains waiting on Kazakh tracks all backed by a snow- capped mountain range. These giant cranes are needed to transship containers onto Kazakh trains and vice versa as Kazakh rail uses slightly wider – former Soviet – rail lines. In addition to the railway terminal a new highway crossing from China to Kazakhstan opened in November 2018.

According to Yu Chengzhong, Chairman of the Board, already 45 percent of the port’s cargo originates from outside Xinjiang. He explains how provinces closer to the sea are switching to the overland route; from oranges in Hunan, to consumer products in Zhenzhou.

The development of the dry port has been impressive: productivity at the port has rocketed in recent years and it now handles over 180,000 TEUs a year, Yu told Beijing Review. That figure is expected to rise to 500,000 TEUs by 2023.

“Before the port was built it would take three days to reach Astana in Kazakhstan, all on dirt roads,” Yu continued to explain, “but now it’s all express highway or rail freight so the time is just hours now.”

Although some eighty percent of the goods shipped through Horgas go to the countries of the former Soviet Union, and 35 to 40 percent go to Uzbekistan alone, on January 3rd 2017 the first Yiwu to London train departed carrying 44 containers via Moscow and Minsk arriving at London’s Barking Eurohub freight terminal. On April 10th that same year the first London to Yiwu train departed carrying 88 containers covering the 12,000 km journey in just 18 days compared with 40 days for sea freight.

Added to this, the Port at Horgas provides a train route – via Almaty and across central Asia – to Tehran, with the first cargo trains arriving from China in 2018 after completing the 10,400 km journey in just 14 days and giving China increased access to this energy rich region.

But development of the port has also been a driver for local industries in Xinjiang. And horticultural projects have sprung up in the Ili Region. Where once there was open grassland, vast fields of flowers bloom and fields of lavender stretch to the horizon.

But Horgas is not Xinjiang’s only trade route under development. Xinjiang’s oasis city of Kashgar has a history stretching back more than 2000 years and was a key trading post along the historical Silk Road. Now it is the start point of China-Pakistan Economic Corridor (CPEC), one of the biggest projects under the Belt and Road Initiative (BRI).

Photo: Ryan Perkins

Over the course of decades roads have been built – with great hardship and many challenges given the formidable terrain – from Kashgar to Pakistan’s Gwadar Port allowing Chinese cargo to be transported overland to the port. Gwadar Port is located at the mouth of the Persian Gulf, just outside the Strait of Hormuz, with access to the key shipping routes in and out of the Gulf.

Gwadar Port is central to the CPEC, and a key component in the BRI. China Overseas Port Holding Company plans to expand the port, constructing nine, new multipurpose berths. Construction and operation of the port was awarded to China in 2013 and it gives China an alternative to potential choke points like the Straits of Malacca.

Heather Fields in the Desert
Source: Ryan Perkins

This huge level of investment in Xinjiang’s infrastructure is feeding back into local communities in many ways; presenting new business opportunities, opening new markets and helping facilitate China’s poverty alleviation campaign. Given Xinjiang’s strategic position and increased connectivity with Central Asia and the Eurasian landmass at large, the region is no longer a landlocked backwater; but becoming a land-linked logistics hub.

Money Printer Go Brrrr -Asset Bubble Inflation and De-Dollarization

A version of this article originally appeared in Beijing Review.

With the U.S. economy still reeling from the COVID-19 pandemic and record unemployment, real estate prices continue to skyrocket pricing thousands of house hunters out of the market in the U.S. and Canada. This may seem counterintuitive for an economy that has technically been in recession since February 2020 and saw unemployment peak at just over 14% last April. The last time U.S. home prices raised this quickly, it led to an ensuing crash that brought down the global economy.

This asset bubble is not restricted to the US but is crossing borders and going global making housing or even renting unaffordable for many – especially those worst affected by the global pandemic. In fact the rate of price increases has alarmed policy makers in both the U.S. and Canada. “The dream of homeownership is out of reach for so many working people,” Senate Banking Chair Sherrod Brown told Politico recently. “Rising home prices and flat wages means that many families, especially families of color, may never be able to afford their first home.”

According to World Population Review “the typical value of U.S. homes was $269,039 as of January 2021, a 9.1 percent increase from January 2020. Between 1999 and 2021, the median price has more than doubled from $111,000 to $269,039.

Canadian Prime Minister, Justin Trudeau has also weighed into the topic recently in a statement saying that the cost of owning a home is too far out of reach for too many people in Canada’s largest cities, noting it can take 280 months for an average family to save for a down payment in a place like Toronto or Vancouver – a favorite with Chinese migrants.

But real estate is not the only asset class that is being inflated; both the NASDAQ and S&P 500 have increased by nearly 40% in the last 12 months despite unemployment near record COVID highs in the U.S. The NASDAC increased by 39.51% in the last 12 months while the S&P 500 rose 38.46% over the same period.

Source: Yahoo Finance
Source: Yahoo Finance

The source of this asset bubble inflation is the Federal Reserve’s policy of Quantitative Easing or QE – a term economist use to describe printing money and using it to buy back domestic treasury bonds from banks and other financial institutions.  This, in theory, is designed to reduce the interest rate and encourage lenders to lend to industry or individuals to stimulate the ‘real’ or productive economy.

In reality, much of this ‘free money,’ as Professor Michael Hudson, financial analyst and president of the Institute for the Study of Long-Term Economic Trends, contends is instead used to speculate on assets both domestic and international – particularly in emerging markets where the biggest and quickest gains can be made. In essence, QE disproportionately benefits those closest to the Fed. These asset bubbles show no sign of abating as the US is expected to approve an addition 2 trillion in stimulus this year and the Fed has said it won’t take it’s foot off the pedal when comes to pumping liquidity into the market.


Source: FRED
The chart above shows the growth of money supply from the Federal Reserve since 2002. Note the volume doubled during the Financial Crisis of 2008. From then on the economy continued to be buoyed up with periodic bouts of money printing before rocketing during the 2020 COVID-19 pandemic.

With many of these dollars being spent abroad the central banks of the receiving countries keep them and pay the receiver in local currency. But what can central banks around the world do with all these dollars.

As congress often blocks attempts to purchase U.S. companies and assets under the guise of national security – as with the Chinese oil company CNOOC’s $18.5 billion bid for Unocal in 2005 – there is only really one option left; to purchase U.S. Treasury Bonds or T-bills to further underwrite U.S. debt. All of this is made possible because of the U.S. dollar’s unique status as the world’s reserve currency.

Source: FRED
The graph shows how Federal Reserve money supply has nearly doubled in the last 18 months.

Aside from printing money ad infinitum, this special status as global reserve currency gives the U.S. another ability. Namely, to sanction countries or individuals that do not align with their foreign policy objectives. Potentially, it gives the U.S. the ability to essentially turn off the economies of counties that don’t follow U.S. hegemony for whatever reason. But it is this threat and the increasingly liberal use of unilateral sanctions that are leading some economies to attempt to de-dollarize their economies and insulate them from economic bullying.

One such country is Russia. On June 3, the Kremlin announced its policy outline for de-dollarization. The plan to abandon the US dollar was developed by the government in response to tougher US sanctions. Finance Minister Anton Siluanov announced plans to reduce the share of the dollar in the Russian National Wealth Fund (NWF) to zero.

“I can only say that the de-dollarization process is constant,” said Siluanov, expressing doubts about the reliability of the main reserve currency, at a press conference at the St. Petersburg International Economic Forum. According to him, this process is taking place not only in Russia, but also in many countries. “We made a decision to withdraw from dollar assets completely, replacing them with an increase in euros, gold, and other currencies,” the minister said.

According to him, as the share of the dollar is reduced to zero, the share of the euro will be 40%, the yuan 30%, gold 20%, pounds and yen 5% each. Siluanov, noted the replacement will take place “rather quickly, perhaps within the month”. Even before the Ministry of Finance announcement, the Bank of Russia carried out a large-scale restructuring of its gold and foreign exchange reserves, shifting about $100 billion in 2018 into euros, yuan and yen.

Added to this, at the end of 2019, several European countries set up a new transaction channel designed to facilitate companies to continuing to trading with Iran despite US sanctions after President Donald Trump unilaterally withdrew from the nuclear agreement or the Joint Comprehensive Plan of Action (JCPOA).

Set up by Germany, France and the UK, the ‘Instrument in Support of Trade Exchanges’ or INSTEX gives European companies the capacity to bypass the U.S. controlled SWIFT banking system – a network that enables financial institutions worldwide to send and receive information about financial transactions and one of the main tools for U.S. sanctions.

“We’re making clear that we didn’t just talk about keeping the nuclear deal with Iran alive, but now we’re creating a possibility to conduct business transactions,” German Foreign Minister Heiko Maas told reporters at the time.

In addition, China launched its Cross-border Interbank Payment System (CISP) in 2015. CISP is a payment system which offers clearing and settlement services for participants in cross-border yuan payments and trade.

At the start of the 21st Century the idea of de-dollarizing global trade seemed insurmountable. But now it seems as if the COVID-19 pandemic and America’s response may be accelerating the process faster than many imagined possible.