china


Screen Shot 2015-11-18 at 4.55.47 PM

People in the West, certainly Americans, have long had a fascination with the East, with many predicting an inevitable “Asian century” marked by economic and market dominance. I have long disagreed with the consensus on China and other Asian Tigers, and others are beginning to agree. Many problems stand in the way of the “Asian century.”

Japan dazzled Westerners with the speed of its recovery from the ashes of World War II. Japanese purchases of U.S. trophy properties such as the Pebble Beach golf resort in California and Rockefeller Center in Manhattan in the 1980s, on top of the leaping property and equity prices in Japan, convinced many in the West that Japan would soon take over the world.

Japan’s economic decline in the early 1990s did not curb fascination with Asia. It simply shifted to the rapidly-growing developing economies, the Asian Tigers. The original four, Hong Kong, Singapore, South Korea and Taiwan, were later augmented by the likes of Malaysia, Thailand, the Philippines and, of course, China — and more recently, Pakistan, Vietnam, Indonesia and Bangladesh.

The late-1990s Asian financial crisis only temporarily disrupted Western fascination with the East and the prospects for an “Asian century.”

The 2007-2009 Great Recession and financial crisis ended rapid economic growth in Western countries and, therefore, the robust demand for exports that were the mainstay of developing economies. Still, Western zeal for Asia persisted and many, for no logical reasons, believed emerging countries could independently continue to grow rapidly and, indeed, support economic activity in the sluggish U.S. and Europe.

Chinese real economic annual growth rates nosedived from double digits to a recessionary 6.3 percent during the worldwide downturn, but then revived due to the massive 2009 stimulus program. Easy credit fueled a property boom and inflation, and excessive infrastructure spending replaced exports as the growth engine. As with the Asian Tigers earlier, many thought Chinese growth was self-sustaining and unrelated to ongoing sluggish economic performance in North America and Europe, especially after Chinese GDP topped Japan’s in 2009.

There are five main reasons why it won’t get any easier for Asia:

1. Globalization is largely completed. There isn’t much manufacturing in North America and Europe left to be moved to lower-cost developing economies. At the same time, the West is basically saturated with Asian exports, and those countries are competing fiercely among themselves for limited total export demand. Also, exports are shifting among those countries as low-end production moves from China to places such as Pakistan and Bangladesh, much as they shifted out of Japan in earlier decades. As economies grow, a greater share of spending is on services and less on goods. This reality is a long-term drag on almost all the other Asian lands, except India, due to their goods-export orientation. This will temper long-term growth for Asian goods exports even after rapid economic growth resumes in the U.S. and possibly other Western economies.

2. The shift from being export-led economies to ones driven by domestic spending, especially by consumers, has been slow. Chinese leaders want this transition, but it is moving at glacial speed. At 37 percent, Chinese consumer spending as a share of GDP is well below major developed countries such as the U.S. at 68.1 percent, Japan at 58.6 percent, and even Russia at 51.9 percent.

3. There are government and cultural restraints. Almost all developing Asian economies are tightly controlled by governments. Top-down regimes stoutly resist reform and often persist until they’re overthrown by revolutions. The current Mao dynasty in China, as I’ve dubbed it, seems seriously worried about popular unrest due to the lack of promised economic growth and is reducing what little political liberty was previously allowed. President Xi is now the Big Brother with lots of little brothers insuring proper thoughts and actions, even at the local level.

In Malaysia, Prime Minister Najib Razak is enmeshed in a multibillion-dollar investment scandal. In the Philippines, crime and drug trafficking are so rampant that President Rodrigo Duterte was elected on a platform of eliminating drug dealers, even by murderous vigilante squads. South Korea’s former president Park Geun-hye was thrown out over corruption.

4. Population problems endure. Despite the need for new workers in Japan as its population falls and ages, women are still discouraged from entering the labor force, and Japan continues to be unwelcoming toward newcomers. There’s no such thing as an immigration visa despite the fact that 83 percent of Japanese hiring managers have difficulty filling jobs, versus a global average of 38 percent in the last five years.

China also has a looming labor shortage and severe limits to economic growth due to its earlier one-child policy, which resulted in about 400 million Chinese not being born. Low fertility rates are also destined to reduce the populations of Hong Kong, Taiwan, Singapore and South Korea. At the other end of the population spectrum are Asian countries like Indonesia and India, whose population is expected to exceed China’s by 2022.

5. Military threats are growing in Asia, and could severely disrupt stability and retard economic growth if they flare up. China is exercising its military muscles by challenging U.S. military influence in the region by, among other actions, building military islands on reefs in the South China Sea. Japan is abandoning its post-World War pacifism and shifting from defensive to offensive capabilities. The Russians are also making military threats. The region contains five nuclear-armed countries: China, India and its rival Pakistan, Russia, and — most troubling — North Korea, which is testing long-range missiles. China isn’t happy about that, but it wants North Korea as a buffer between it and South Korea as well as a deterrent to its old foe, Japan.

The long-promised Asian Century of global leadership is unlikely to come to pass due to the completion of globalization, the slow shift from export-led to domestic-spending-driven economies, government and cultural restraints, aging and falling populations, and military threats.

The fascination with Asia started with Japan’s dazzling economic recovery after World War II, which culminated with purchases of U.S. trophy properties such as the Pebble Beach golf course and Rockefeller Center in the 1980s. Rising property and equity prices convinced many in the West that Japan would soon take over the world, but those bubbles burst in late 1989, sending the Nikkei index down 63 percent in less than three years and real estate prices down by 59 percent. Japanese economic growth has averaged just 1.1 percent since then.

With Japan’s decline, Western fascination shifted to the rapidly growing developing economies of the Asian Tigers, but the regional financial crisis that commenced in Thailand in 1997 started a domino-like collapse of neighboring financial markets and economies. With the 2007-2009 recession and financial crisis, export-led Asia suffered along with the economies of the U.S. and Europe. Yet Westerners didn’t abandon Asia, but shifted their admiration to China.

Chinese real economic annual growth rates nosedived from double digits to a recessionary 6.3 percent during the worldwide downturn, but then revived thanks to the huge 2009 stimulus program. Easy credit fueled a property boom and inflation, both of which were unwanted by Chinese authorities. Also, the growth in exports rebounded back to the 20 percent to 30 percent annual rates seen before the recession. As with the Asian Tigers earlier, many thought Chinese growth was self-sustaining and unrelated to ongoing sluggish economic performance in North America and Europe, especially after China’s gross domestic product topped Japan’s in 2009.

But like virtually all developing economies, China’s has been driven by exports that directly or indirectly are sold to North America and Europe. And those imports by the West are fundamentally curtailed by sluggish overall economic growth — the result of deleveraging, the working off of excess debt built up in the exuberant 1980s and 1990s. Annual Chinese export growth dropped from 20 percent to 30 percent in the 2000s to negative territory in February.

Further, globalization is largely completed, curbing that source of emerging-economy advance. And China’s huge total economic size had covered up its still-underdeveloped status. Even with the explosive growth in the past several decades, Chinese GDP per capita in 2016 was $8,030, or just 14 percent of the U.S.’s. Meanwhile, consumer spending in China amounts to just 37 percent of GDP compared to 68.1 percent in the U.S.

China won’t shrivel up and die, but it will be a much less important actor on the global stage as it shifts from commodity-munching exports, housing and infrastructure to consumer spending and services. The same was true of Japan starting in the early 1990s.

There may well be an “Asian Century,” but don’t hold your breath. It took about a millennium for the West to develop meaningful democracy, the rule of law, large middle classes that support domestic economies, and all the other institutions that are largely lacking in developing Asian lands at present.

5. Disinflation that started in 1980 continues with chronic deflation likely, especially as services follow goods in price retreats. The Federal Reserve and every other major central bank have a 2 percent inflation target. They don’t love inflation, which devastated economies and financial markets in the 1970s, when it rose to double-digit levels. But they fear deflation, which curbs consumer spending and capital investment along with economic growth as deflationary expectations set in. When price declines are widespread and chronic, buyers anticipate further declines so they wait for even lower prices. The resulting excess capacity and unwanted inventories force producers to cut prices further. Suspicions are confirmed, so buyers wait for still-lower prices in a self-perpetuating spiral. So deflation is self-feeding, as seen clearly for two decades in Japan.

Also, with deflation, the real cost of debts rises, making them harder to service and inducing financial problems and bankruptcies.

I remain convinced that widespread inflation results from overall demand exceeding supply, and deflation is caused by the reverse. Historically, governments create inflation in wartime with robust spending on top of fully-employed economies. That was the case in the late 1960s and 1970s, when Vietnam War outlays combined with War on Poverty spending. And that led to double-digit inflation rates by 1980. In peacetime, however, supply normally exceeds demand and deflation prevails. In the 96 years of war since 1749, wholesale prices rose 8.2 percent per year on average, but fell by 0.45 percent annually in the 170 years of peace. Assuming that the Trump administration, China, Russia and Middle East terrorists don’t drag the U.S. into a significant armed conflict, deflation is more likely in the years ahead, at least by historical precedent.

6. “The bond rally of a lifetime” that I first identified in 1981, when 30-year Treasuries yielded 15.2 percent, continues. With their safe-haven appeal, lower interest rates abroad and prospective deflation, we look for 2.0 percent yields on the long bond and 1.0 percent on the 10-year Treasury note.

I’ve been pretty lonely as a Treasury bond bull for 36 years. Stockholders and others may hate them, but their quality is unquestioned, and Treasuries and the forces that move yields are well-defined: Federal Reserve policy and inflation or deflation.

In addition, I’ve always liked Treasury coupon and zero-coupon bonds because of their three sterling qualities. First, they have gigantic liquidity with hundreds of billions of dollars’ worth trading each day. So all but the few largest investors can buy or sell without disturbing the market.

Second, in most cases, they can’t be called before maturity. This is an annoying feature of corporate and municipal bonds. When interest rates are declining and you’d like longer maturities to get more appreciation per given fall in yields, issuers can call the bonds at fixed prices, limiting your appreciation. Even if they aren’t called, callable bonds don’t often rise over the call price because of that threat. But when rates rise and you prefer shorter maturities, you’re stuck with the bonds until maturity because issuers have no interest in calling them. It’s a game of heads the issuer wins, tails the investor loses.

Third, Treasuries are generally considered the best-quality issues in the world. This was clear in 2008 when 30-year bonds returned 42 percent, but global corporate bonds fell 8 percent, emerging market bonds lost 10 percent, junk bonds dropped 27 percent, and even investment-grade municipal bonds fell 4 percent in price.

Treasuries sold off with the “Trump Trade” after his election, but revived recently. This reflects deflation prospects since inflation rates and Treasury yields move together — up in the post-World War II years up until 1980 and then down ever since. Treasuries have also rallied lately due to their safe-haven status and thanks to having a higher yield than other developed country sovereigns, making them more attractive to foreign investors.

 

Screen Shot 2015-11-18 at 4.55.47 PM

The strength of the US dollar is forcing China down a path it has been trying to avoid for years, pushing it to slow the money machine that has propelled its economy since 2008.

The course of this path could mean strange and terrible things are in store for economies around the world. A slower, weaker Chinese economy — and the resulting weakness of the yuan — will create competition for other developing-market exporters in a race to the bottom.

This is a moment many China watchers have been waiting for — it just didn’t come how, when, or why they thought it would.

The money machine is China’s state-run banking sector. Through loans, the banks pumped cash into the economy at an unprecedented rate — as the rest of the world watched and worried. The International Monetary Fund harped on China’s debt for years, and across Wall Street, money managers have often gotten slaughtered betting on China’s demise (in one way or another) as debt climbed to 280% of GDP.

China’s leadership seemed to not hear these concerns until recently, when officials did something very strange: Party leaders got together to tell apparatchiks down the chain that they needn’t worry about hitting growth targets.

This means that a country infamous for its obsession with hitting the numbers is setting them aside in the face of mounting debt.

You can see where this change comes from: At the end of 2016, the US dollar started rising, the yuan started weakening, and people started to quickly take money out of the country to keep their savings from losing value.

Now “we are in uncharted territory,” Charlene Chu, a famed China analyst at Autonomous Research, wrote in a recent note titled “The war on outflows.”

We are now seeing that as the US gradually ends its postcrisis monetary easing program, China will be forced, in some measure, to do so as well. In many ways, though, the country is not ready.

To understand how it’s ever so slowly falling apart, we have to understand how the Chinese economy held together in the first place.

After 2008, the Chinese government kicked off its own program to avoid the global financial crisis. It did not do it the way the US did, though. Instead of having its central bank buy bonds, the Chinese government instructed its banks to lend. And they did, adding 30% or more credit to the economy every year, according to Chu.

Now there is 165 trillion more yuan ($23.8 trillion) in circulation than there was eight years ago. At the same time, the value of the yuan has remained virtually the same — an unnatural state in economics, to be sure.

The result has been an increase in purchasing power for Chinese people — a promise the Chinese Communist Party made and kept.

But it also created an imbalance between the increasing amount of yuan in circulation and the steadiness of the currency’s value that “will only continue to grow if the CNY does not weaken materially and China’s financial sector continues to expand at double-digit rates,” Chu wrote (emphasis ours).

Now, keep in mind that a double-digit expansion of the banking sector is something of a jog considering what China’s used to.

“Total banking sector assets in China will increase [by 30 trillion yuan] to [228 trillion yuan] in 2016 alone, and another [100 trillion yuan] will be added to this by 2020 if the banking sector grows at 10% per annum, which, we would note, would be the lowest growth rate on record,” Chu wrote.

Last month, $82 billion left China, as the government was forced to fix its currency lower and lower against the dollar and people worried about the value of their assets.

And despite the fact that China’s leaders have tried to tell the world that the yuan is now fixed against a basket of currencies, not just the dollar, it doesn’t matter. We still live in a dollar world.

Consequences

Now instead of growth, the Chinese government’s main concern is keeping capital in the country. To do so, it has instituted several capital controls for individuals and corporations, but, of course, there are always ways to get around things like that.

Plus, holding the yuan steady comes at a cost. The Chinese government is spending its foreign-exchange reserves to prop up the currency. Right now it’s holding about $3 trillion, but Chu sees this working for only the next two quarters. A more permanent solution must be found.

So the government also has to think about attracting money to the country, and that’s where the gears of this great money-making machine start to ever so slowly grind down.

One way China can attract money is by raising interest rates, which would have consequences for all the borrowers who have taken on unprecedented levels of debt.

The flow of yuan around the country would tighten, cooling the property market. This is important. Property-market growth is part of what turned 2016’s rocky start into a net positive year for China.

“Liquidity and market risk vulnerabilities in the financial sector will be more on display,” Chu wrote. In other words, some of the hands that distributed yuan around China would be impaired, taking a toll on the country’s heavily indebted corporations.

This is why the Chinese government is being forced to prepare its people, and the world, for a slowdown. For the world, this ultimately means deflation — a force it has been fighting since the start of the financial crisis — as the yuan declines and other countries try to keep up (or down). All China can do in the meantime is what it’s doing right now: fixing the yuan higher, no matter what the dollar does.

Regardless, as the economy slows the currency will glide down. It will have to. Chu estimates that if the government continues to support the yuan against market pressure, it could blow through its foreign-exchange reserves in a couple of years.

Some caveats, of course

Two things to keep in mind here. First, the dollar could weaken.

“I do think that it’s likely to be supported by the Fed raising rates again, but I really doubt that the dollar [index] is going to make it above 120,” Jeff “Bond King” Gundlach of DoubleLine Capital predicted in his most recent monthly investment outlook presentation.

That, of course, would take pressure off the yuan and help with outflows. But this wouldn’t stop this process; it would only slow it. No matter what happens, the Chinese economy is building up dangerous debt levels that must be dealt with, and China has acknowledged that the economy’s growth will slow. The imbalance between the yuan in circulation and its value remains, and that in and of itself will push the yuan’s value down.

“One thing that is increasingly clear to us is that the world’s largest source of monetary easing since 2008 won’t be passing through in the way it has been, whether that is from a closing of the gates on outflows or a fall in the purchasing power of Chinese companies and individuals through a weakening of the exchange rate,” Chu wrote.

Second, this will happen incredibly slowly. The catastrophic credit event that Wall Street’s wildest minds have wondered about is unlikely to happen. The Chinese government has control over too much of its economy and can pull and push levers such as interest rates and manipulate the money supply however it likes.

Increasingly, economists think China will look like a poorer Japan, declining into drudgery in unexpected ways to ease its transition into a painfully slow-growing economy.

Either way, it isn’t entirely a mystery where we’ll go. What’s more unprecedented is how we’ll get there.

China has shown its hand. We now know what a dollar can do — and how little China can do to stop it.

Screen Shot 2015-11-18 at 4.55.47 PM

Chinese “depreciation” and all its ensuing hysteria occurred just about a year ago. It has also been a about a year since I co-wrote a book on China with Worth Wray titled A Great Leap Forward?

The title was meant to be ironic. The original Great Leap Forward was imposed by Mao in the 1960s. It was one of the most economically disastrous times in Chinese history. Food production increased, yet 30 million people starved. China underwent a true financial and economic crisis due to the insanity of central control of markets.

China now attempts something that is as powerful in scope as Mao’s Great Leap Forward. It has amassed a huge amount of debt in its drive to enter the modern world. China has succeeded in becoming a major force. But those who are paying attention see the country’s debt growing at a phenomenal rate.

It is much higher than the economy’s rate of growth, which is shrinking. That means the ability to service the debt is shrinking, too. And we are talking about massive amounts of debt in relation to GDP.

There is a lot to like and appreciate about China. But it isn’t clear what they are going to do about their current circumstances. This includes the inevitable shift from being a manufacturing powerhouse to being a consumer powerhouse. It’s not an easy transition.

My friend Michael Pettis is a professor at the Guanghua School of Management at Peking University in Beijing. I think it’s safe to label him a long-term China insider. He’s possibly the most knowledgeable person I know on China’s inner workings.

Here is his latest article on the nature of Chinese debt and the problems that the resolution of that debt is going to create.

Does It Matter If China Cleans Up Its Banks?

By Michael Pettis
I’ve always thought that Shirley Yam of the South China Morning Post has a great nose for financial risk, and this shows in an article she published last week on mainland real estate. For anyone knowledgeable about the history of financial bubbles and crises, much of the following story will seem extremely familiar. The point to remember is that what is normally recorded as business operations in activities described in the article, results in fixed payments that are inversely correlated with underlying conditions, and so is really no different than debt in the way it will begin to generate financial distress costs when the economy turns—goosing economic activity on the way up while exacerbating the contraction when it comes.

Yam discusses how building contractors must pay developers to build real estate projects and write about one such contractor, whom she calls “George”:

This is how the system works. Say an apartment building costs 1 billion yuan to build. George will provide the developer 300 million yuan as “facilitation money” at an interest rate of about 4 percent to win the job. The latter will then give George 80 million yuan for the services rendered.

George, however, does not have any shareholding in the project, whatsoever, to cover his back. Neither is he assured that the facilitation money would not end up in the stock market. All George can do is pray and hope that the apartments sell well and he gets his money back with interest plus the construction costs. Despite the risk, there has been no dearth of interested players. As George puts it, it has been getting worse. His state-owned rivals are now offering “facilitation money” of up to 50 or even 60 percent of the construction cost. Some are even pitching in with zero interest, while others are promising to help in eventual sales.

She goes on to talk about the desperate competition among developers to get new projects, and what is driving the record-beating real estate prices:

The obvious question that comes to mind is why are developers willing to pay record amounts to own a piece of land—or as some suggest, pay more for the flour (land) than the bread (flat). But then the land parcels are not really meant to be the flour for the bread. A good case is China Cinda Asset Mangement, which has invested more than 61 billion yuan in property during the past 12 months.

Among its acquisitions was a piece of land in suburban Beijing that was so expensive that it will break-even only if the property prices are four times higher. But Cinda has piles of liquidity to splash about. Its debt to equity ratio rose by a third to 368 per cent in 2015 and it paid just a quarter of the loan rate of its private rivals. For Cinda, property seemed the best bet. After all, the real economy was not going anywhere and the stock market was twisting and turning. On the other hand, property investment promised huge returns and was more self-fulfilling in nature. The record-breaking land prices support the property market and therefore the repayment of the multi-billion yuan of loans via shadow banking that Cinda and other state firms are loaded with. So overpayment seemed perfectly okay.

Keep all of this in mind when thinking about stepped-up efforts to clean up China’s banking system. There has been a flurry of reports recently about steps taken to clean up the banking system, but from an economy-wide point of view, it is not clear that any reduction in debt burden’s for the banking system actually reflect a reduction in the debt burden for the economy as a whole. And anyway, new kinds of debt are growing quickly enough that even if it did, the country’s debt burden is almost certainly rising.

Here is Bloomberg on a UBS report two weeks ago on the topic of bank clean-ups:

The good news is that the capital raises have begun. The bad news is that they need to continue. An analysis of 765 banks in China by UBS Group AG shows that efforts to clean up the country’s debt-ridden financial system are well underway, with as much as 1.8 trillion yuan ($271 billion) of impaired loans shed between 2013 and 2015, and 620 billion yuan of capital raised in the same period. But the work is far from over, as to reach a more sustainable debt ratio, the Chinese banking sector will still require up to 2 trillion yuan of additional capital as well as the disposal of 4.5 trillion yuan worth of bad loans, according to the Swiss bank’s estimates.

I think a lot of this misses the point, and not just because there is a lot more debt out there than we think. I think the optimism with which this news has been received reflects a failure to think systemically about the Chinese economy. The fact that bad loans overwhelm the capital of the banking system should not blind us to the fact that China’s problem is excessive debt in the economy, and not a banking system that risks collapse because of insolvency. The only “solution” to excessive debt within the economy is to allocate the costs of that debt, and not to transfer it from one entity to another.

The recapitalization of the banks is nice, in other words, but it is hardly necessary if we believe—and most of us do—that the banks are effectively guaranteed by the local governments and ultimately the central government, and that depositors have a limited ability to withdraw their deposits from the banking system. “Cleaning up the banks” is what you need to do when lending incentives are driven primarily by market considerations, because significant amounts of bad loans substantially change the way banks operate, and almost always to the detriment of the real economy.

Debt matters, not merely its location

Cleaning up the banks is much less important, however, when lending incentives are driven mainly by policy and there is widespread moral hazard. What matters is the impact of overall debt on Beijing’s ability to implement policies that work as expected, and its impact in generating economy-wide financial distress costs.

The key in China, in other words, is not whether the banks have been cleaned up. It is how the losses are going to be allocated, and that remains no clearer today than it ever has been. Until the losses are allocated, they will simply show up in one form or the other of government debt. Because debt itself is constraining growth—I expect it to force economic activity to drop to less than half current levels well before the end of this decade—the debt must be written down or paid down and its costs must be allocated, the sooner the better for China.

But that is of course, easier said than done. I have already discussed many times why the losses should not be allocated to the household sector or the SME sector. Allocating it to the former worsens the imbalances and makes economic activity more dependent than ever on increases in investment, to which China will soon reach limits. Allocating it to the latter would undermine the only really efficient part of the economy and so disrupt any chance China has of long-term growth. The losses also cannot be allocated to the external sector because it isn’t large enough, and it will not be allocated to the central government as long as the leadership believes it necessary to continue centralizing power. In the end, the losses can only be allocated to local governments, but that has proven politically impossible.

I warn my clients that while all the excited chatter about reformist froth in the formal and informal banking sectors may seem like progress is being made or not made—and of course will have some impact on the stock selection process—in the end, they should not take their eye off the ball. China’s problem is that to keep unemployment low, the government must rely on a rising debt burden powered by surging non-productive investment. The only way to constrain the growth in the debt burden and keep unemployment from soaring is to allocate the debt-servicing and adjustments costs to whichever sector of the economy is able to bear it with the least damage to China’s longer-term economic prospects.

This process is not being helped by a slowdown in the growth in household income. A July article in Bloomberg explains and presents a graph that shows cumulative disposable income per capita dropping quarter by quarter over a two-year period from 8.5% to 6.5% as GDP drops over that period from 7.5% to 6.7%:

Chinese consumers, whose spending helped underpin the first-half expansion this year, may not be able to deliver a repeat performance in the second as income growth slows. Household income growth slumped to 6.5 percent in the first six months from 7.6 percent a year earlier, data released Friday showed. Headwinds on consumer spending may increase as officials signal they will step in to curb pay gains to keep manufacturing competitive with rival nations that have cheaper production costs.

As shoppers become an increasingly crucial growth driver, any erosion of their strength would weaken the ability for the consumer-led expansion to offset weakness in exports and investment. That threatens the government goal of raising gross domestic product by 6.5 percent a year through 2020 and slow the rebalancing away from factory-led growth.

The conclusion is inexorable. Beijing must find a way of generating domestic demand without causing China’s debt burden to surge, which basically means it must rebalance the economy with much faster household income growth than it has managed in the recent past, and it must begin aggressively writing down overvalued assets and bad debt to the tune of as much as 25-50% of GDP without causing financial distress costs to soar. Everything else is just froth.

Can China “grow out” of its debt burden?

After many years of assuring the leadership that the debt burden was easy to manage and that reforms would resolve the problem of growth, economic policy advisors have still not been able to prevent the balance sheet from deterioration. They continue to promise that with the right combination of efficiency-enhancing reforms—and there seems to be a dispute among one group arguing for “demand-side” reforms and another for “supply-side” reforms—Chinese productivity will rise by enough to outpace the growth in debt.

But this will almost certainly not happen. Simple arithmetic indicates that the amount by which productivity must rise to resolve debt servicing is implausibly large and requires an unprecedented amount of efficiency enhancement. In the newsletter I sent out to clients on June 28, I calculated that if we believe debt is equal to 240% of GDP, and is growing at 15–16% annually, and that debt-servicing capacity is growing at the same speed as GDP (6.5–7.0%), for China to reach the point at which debt-servicing costs rise in line with debt-servicing capacity, Beijing’s reforms must deliver an improvement in productivity that either:

  1. Causes each unit of new debt to generate more than 5–7 times as much GDP growth as it does now, or
  2. Causes all of the assets backed by the total stock of debt (which we assume to be equal to 240% of GDP) to generate 25–35% more GDP growth than they do now.

If we change our very conservative assumptions so that debt is equal to 280% of GDP, and is growing at 20% annually, and that debt-servicing capacity is growing at half the rate of GDP (3.0–3.5%, which I think is probably still too high), for China to reach the point at which debt-servicing costs rise in line with debt-servicing capacity, Beijing’s reforms must deliver an improvement in productivity that either:

  1. Causes each unit of new debt to generate 18 times as much GDP growth as it is doing now, or
  2. Causes all assets backed by the total stock of debt (280% of GDP) to generate 50% more GDP growth than they do now.

These levels of productivity enhancement do not seem very plausible to me, and I do not think it is possible for reforms to improve efficiency by nearly enough to solve the country’s debt problem. What is worse, the historical precedents indicate that while many debt-burdened countries have attempted the same efficacy-enhancing reform strategy, there does not seem to be any case in which this strategy has actually worked. No highly-indebted country, in other words, has been able to grow its way out of its debt burden until after it has explicitly or implicitly paid down or written down the debt. There are different ways in which this history has been exemplified:

  • In some cases, as in Mexico in 1989, after many years of struggling unsuccessfully to implement productivity-enhancing reforms and suffering from low growth and economic stagnation, governments finally obtained explicit write-downs of the debt when the debt was restructured with partial debt forgiveness (35% of the nominal amount, in the case of Mexico). In this case, the cost of the write-down was allocated to foreign creditors, although during the many years of stagnation workers paid for financial distress costs through unemployment and suppressed wage growth.
  • In some cases, governments never restructured their debt, and so never explicitly obtained debt forgiveness, but they did monetize the debt and so obtained implicit debt forgiveness through high levels of inflation (as was the case of Germany after 1919) or through financial repression (as was the case of China’s banking crisis at the end of the 1990s), or both (as was the case of the UK after 1945), in which the cost of writing down the debt was mostly absorbed by household savers. This last point is important because it creates a great deal of confusion among analysts who think that China can resolve its debt problem the same way it did fifteen years ago. China effectively forced the debt-servicing cost onto household savers mostly during the first decade of this century. With nominal GDP growth ranging between 16% and 20% and a GDP deflator between 8% and 10%, lending rates should have probably been at least 13-15%, but instead they were set much lower, between 6% and 7%, and deposit rates even lower, between 2.5% and 3.5%. Negative real lending rates effectively granted insolvent borrowers debt forgiveness every year equal to at least 6–9 percentage points for a decade or longer. Depositors effectively paid for the full amount of the debt write-down as well as to recapitalize the banks. Forcing the cost of the write-down onto household savers worsened China’s imbalances significantly, however. The household consumption share of GDP fell from a very low 46% in 2000 to an astonishing 35% in 2010. This was not a coincidence.
  • In other cases in which governments never defaulted or restructured their debt—and so never explicitly obtained debt forgiveness—they implicitly wrote down the debt not by monetizing it but by means that involved allocating the costs to the wealthy in the form of expropriation or to workers in the former of wage suppression.
  • Finally, in other cases—the most obvious example being Japan after 1990 and now parts of Europe after the 2009 financial crisis—governments never explicitly or implicitly wrote down the debt, and have instead spent many unsuccessful years attempting to implement reforms that will allow them to grow their ways out of their debt burdens. They have failed so far to do so, and after so many years, it is hard to see how they will succeed.

Resolving the debt burden

Debt must be paid down or written down explicitly, or it will be implicitly amortized over time in an unplanned way and at great cost to the economy. A fundamental part of Beijing’s reform strategy, in other words, must be to reduce the debt burden as quickly as it is politically able in order to minimize the economic costs of economic adjustment and to allow for the most rapid economic recuperation. Reducing the debt burden means selecting the sectors of economy that are best able politically or economically to absorb the cost, and forcing them to absorb the cost of the debt write-down, however reluctant they are to do so.

We typically think of the economy as consisting of four sectors: the external sector, households, businesses, and the government. In China, however, it is more practical to subdivide these further into the following:

  • Creditors. Creditors are forced to absorb the losses associated with writing down the debt when the borrower defaults on its debt and restructures it with a principle or interest reduction. Much of China’s debt burden has been extended through the banking sector, however, and because the debt that must be written down exceeds the banking industry’s capital base, ultimately the cost will be passed on to some other economic sector—for example, Chinese households ultimately absorbed the cost of the banking sector losses generated in the late 1990s.
  • The external sector. To pass on costs to foreigners requires that they have significantly larger exposure to China than they actually do, and would also probably require defaulting on debt—a path Beijing is unlikely to choose to follow.
  • Ordinary households. Most banking crises, like the recent US and European crises and the Chinese banking crisis at the end of the 1990s, are resolved by hidden transfer mechanisms that pass the cost of writing down debt to households. China today, however, must increase household wealth, not reduce it, if consumption is to rise fast enough to allow investment to decelerate. This process will be explained in more detail further on, but it means ordinary households cannot be allowed to absorb the cost.
  • Wealthy households. Given high levels of income inequality and the low propensity to consume of the wealthy, forcing them to absorb the costs of writing down debt—in the form of highly progressive income taxes, for example—is likely to be among the less costly ways economically for Beijing to pass on the costs of paying down debt. As their income or wealth is reduced, the wealthy are likely to convert most of that reduction into lower savings and very little of it into lower consumption, thus minimizing its adverse impact on domestic demand.
  • Small and medium enterprises. Chinese SMEs are among the most efficient economic entities in China and are likely to be the main source of innovation and value creation in the future. Their long-term success is vital to China’s long-term growth. Like ordinary households they should be protected from absorbing the costs of Beijing’s debt-management policies.
  • Local and provincial governments. These have amassed a considerable amount of assets whose liquidation would most efficiently absorb debt write-down costs and would entail the lowest medium and long-term costs. As their assets are liquidated, total Chinese savings will decline and Chinese consumption will remain largely unchanged, thus minimizing the adverse impact on domestic demand.
  • The central government. Beijing too could pay for the cost of writing down debt by liquidating central government assets, although this may conflict with other economic policy objectives, including overcoming vested-interest opposition to the reforms.

These are the major sectors of the Chinese economy within which the cost of debt-management policies can be absorbed, and although there is likely to be a great deal of reluctance on their parts, the most efficient way economically is for the costs to be underwritten by the liquidation of local and provincial government assets and, perhaps to a lesser extent, by taxes on very wealthy households.

It is important to recognize that if debt-servicing costs are not covered by the higher productivity generated by the relevant investment, the process by which the debt will be implicitly or explicitly written down and allocated will necessarily happen anyway, and according to only a limited number of ways. The only question is the extent to which it is directed by Beijing:

  1. Chinese borrowers can default or otherwise restructure debt such that the cost of the write-down is allocated to creditors in the form of a haircut on the debt. Because the creditors for the most part are the banks, which are insufficiently capitalized to bear the full brunt of the losses, these losses will still have to be allocated to some sector of the economy.
  2. If the regulators avoid defaults, there are three further potential outcomes. First, the authorities can implement efficiency-enhancing reforms that cause economic productivity to surge to the point at which excess debt-servicing costs can be covered by the additional productivity.
  3. Second, the authorities can implement reforms that specifically assign excess debt-servicing costs to targeted economic sectors in order to minimize the economic or political costs. For example, it can force local governments to liquidate assets, or it can use taxes to appropriate the wealth of the economic elite—the proceeds of which are then used to absorb excess debt-servicing costs.
  4. Finally, if the authorities do not move quickly enough, excess debt-servicing costs, along with financial distress costs, will be allocated to those least able to protect their interests once debt-capacity limits are reached. There are many ways these costs can be allocated in an unplanned way. One way, and among the most likely, is if the debt is effectively monetized by continuous rolling-over of principle and accommodative monetary policy. While part of the cost may be paid out of an increase in productivity, this is likely to be a small part and can only happen to the extent that unemployment is already very high and the costs of increased production are low. Otherwise, eventually either financial repression or unexpected inflation (with the former more likely than the latter because of the structure of debt in China) will force most of the costs onto household savers and others who are long nominal monetary assets, while unemployment and real wage suppression will force additional financial distress costs onto workers.[1]

Put simply, to the extent that Beijing refuses to follow the first path—and cannot follow the second—it must choose the third path or eventually the fourth will be imposed.

[1] Contrary to what many believe, the PBoC cannot simply monetize the debt. There seems, however, to be a huge amount of confusion about why it cannot. The standard objection is that “China’s ability to monetize this debt will only severely hurt households if it results in a hyperinflation.” This is simply not true, and reflects a misunderstanding of economies whose financial systems are structured in a very different way than that of most Western countries, especially the US.

Screen Shot 2015-11-18 at 4.55.47 PM

Today, the biggest black swan is China, the risk we need to understand above all else. Most investors associate China risk with its economy, the chance of a financial crisis or recession. But the bigger risk today, I would argue, is China’s politics. In the last few months, the country’s political climate has deteriorated at an alarming pace.

British citizens have been abducted in Hong Kong by the Chinese government and censorship of foreign media has increased. Just recently, the 50th anniversary of Mao’s Cultural Revolution-a grim decade when as many as 30 million Chinese are thought to have died of political violence and starvation-was commemorated with a grand concert and celebration. Apparently, the Cultural Revolution is returning to fashion.

We still tend to think of China as that of the government of Deng Xiaoping, who placed China firmly on a liberalizing, market-oriented track. Over three decades, we have become used to China’s 10 percent GDP growth rates and a series of economic achievements, of two power plants opened every week and a new airport for every city.

That China is fading. In its place has arisen a restless and unhappy country. Making a buck has been replaced with making the rest of Asia bow down to Chinese superiority. Power, not money, is the currency of the realm.

The impacts are to be seen both domestically and abroad. At home, Beijing is pressuring foreign businesses. Chinese authorities have shut down Apple‘s iTunes service, and Disney’s joint venture with Alibabahas been pulled. NGO’s are coming under direct police supervision, and many are expected to close. Christian churches are being systematically demolished.

For those of us accustomed to thinking of China as a dynamic, prosperous and constructive power, these developments are hard to digest. Back in 2013, the Rhodium Group, a consultancy with a focus on China, argued the liberal case: “The losses China would incur by reversing its hard-won market reforms far exceed any economic or political dividends from taking such a path” as excluding foreign suppliers. Most business people still feel that way, and it is certainly true.

The evidence, however, suggests that President Xi Jinping does not regard economics as a priority. Indeed, he has specifically denounced “Western capitalist values.” What do these values represent if not personal freedom and economic progress? Xi has stated it explicitly: he rejects capitalism, as westerners might think of it, as his prime objective.

His real priorities are more evident in the country’s foreign policy. The centerpiece of Xi’s policy is the building and militarizing of artificial islands in the South China Sea, with an eye to annexing a 300,000 square mile triangle bounded by China’s Hainan Island to the west, the southern tip of Vietnam and Manila in the east.

Why is China antagonizing literally all its major trading partners with this strategy? China is under no threat in the South China Sea, and the gains, beyond political control, are negligible. The venture fails any reasonable cost/benefit analysis. As a point of comparison, the U.S. Gulf of Mexico produces about $25 billion of oil and gas revenues per year, perhaps $30 billion if other economic activities are added. The South China Sea is considered less promising.

On the other hand, China exported $2.3 trillion goods and services in 2015. A loss of only 1 percent of this trade would offset the full economic benefit of the South China Sea. Why risk it?

The militarization of the South China Sea makes sense only in terms of power politics. As he does domestically, Xi wants dominance abroad, certainly in East Asia. Domination is the goal, even at the cost of economic sacrifice.

The result: The U.S. and China are increasingly facing off in the South China Sea. Last week, China scrambled fighter jets when a U.S. navy ship, in a freedom of navigation exercise, sailed close to the disputed Fiery Cross Reef. If this continues, sooner or later we will find ourselves in a shooting war.

For oil markets, Xi’s policies represent risks great and small. The lesser risk is that the continued crackdown on businesses and foreigners will sap the appetite to invest in and trade with China. At best, the outcome would be sanctions, and at worst, well, something a lot worse. Continued internal and external tensions in China will produce exactly the pattern we have seen, a progressive slowing of the Chinese economy.

There will be no stabilization of GDP growth above 6 percent, but rather a continued unwinding. The Cultural Revolution was no boom time; rather it stands as a Chinese holocaust of poverty, oppression and death. If Xi wants to be the new Mao, then China’s economy will perform as it did under Mao.

What are the implications for oil markets? First, oil demand is a function of GDP. If China’s GDP continues to unravel, as it will in the political climate Xi is creating, then China’s oil consumption will disappoint, and oil markets will take longer to clear than currently expected.

We anticipate markets will clear during the summer. On the other hand, a weakening China could put this off by perhaps two quarters. And as importantly, talk of yuan devaluation, which would be implied by unraveling growth, has tended to knock several dollars off the oil price. Should the Chinese economy continue to unwind without outright hostilities, we would expect oil prices to decline less than $12 per barrel from current levels, but meaningful price recovery to be delayed into 2017.

The far greater risk is a shooting war or China’s annexation of the South China Sea. This could lead to oil embargoes, and much, much worse.The only certainty in such an event is that out-of-the-money options will prove a good bet. For now, let’s hope for the best and trust cooler heads will prevail.

Nevertheless, we cannot be complacent. The risk is real. China’s politics has become the black swan we cannot afford to ignore.

Screen Shot 2015-11-18 at 4.55.47 PM

But the second and biggest trigger I’ve been warning about is China’s unprecedented real estate bubble collapsing …

Recall the Japanese at the top of their stock and real estate bubble in 1989. They were buying real estate hand-over-fist, from Pebble Beach to Rockefeller Center to London. Then, after bidding them up, they ended up selling those holdings at big losses.

The Chinese make the Japanese look prudent!

Chinese buyers are bidding up the high end of the top coastal cities in English-speaking countries like they’ll never go down and like they can’t get enough.

We’re talking Sydney, Melbourne, Brisbane, Auckland, Singapore, San Francisco, L.A., Vancouver, Toronto, New York, London …

These markets are considered “Teflon-proof.” They’re not! In fact, they’re some of the greatest bubbles that exist today. China’s leading cities — like Shanghai, Beijing and Shenzhen — are up 700% or more since 2000!

Guess what happens when the bubble wealth in real estate that has built up in China finally collapses?

So does the capacity of the more affluent Chinese to buy real estate around the world. And these are the guys who have by-and-large been driving this global real estate bubble at the margin on the high end!

Bear in mind that Chinese real estate has been slowing and prices falling for over a year. That is precisely why China’s stock market bubbled up 160% in less than one year. When Chinese investors realized they could no longer make easy money in the real estate bubble, they turned to stocks. And after the dumb money piled in, the Shanghai Composite stock index fell 42% in just 2.5 months!

What did the Chinese government do? What any government in denial would do — buy its own stock market with hundreds of billions of dollars! That’s what the U.S. government did when its stock market crashed in late 1929. And sure enough, China’s stocks are following the same pattern to a tee:

 

Snoopy-Typing-Away-1-CVV14J0D95-1024x768

In the fall of 2009, Jim Chanos began to ask questions about the Chinese economy. What sparked his curiosity was the realization that commodity producers had been largely unaffected by the financial crisis; indeed, they had recorded big profits even as other sectors found themselves reeling in the aftermath of the crisis.

When he looked into why, he discovered that the critical factor was China’s voracious appetite for commodities: The Chinese, who had largely sidestepped the financial crisis themselves, were buying 40 percent of all copper exports; 50 percent of the available iron ore; and eye-popping quantities of just about everything else. That insight soon led Chanos to make an audacious call: China was in the midst of an unsustainable credit bubble.

Perhaps you remember Jim Chanos. The founder of Kynikos Associates, a $3 billion hedge fund that specializes in short-selling, Chanos was the first person to figure out, some 15 years ago, that Enron was a house of cards.

He shorted Enron stock — meaning that he would profit if the stock fell, rather than rose — and shared his suspicions with others, including my friend Bethany McLean, who wrote a story for Fortune that marked the beginning of the end for Enron. That call not only made Chanos a small fortune; it also made him famous.

Chanos and his crew at Kynikos don’t make big “macro” bets on economies; their style is more “micro”: looking at the fundamentals of individual companies or sectors. And so it was with China. “I’ll never forget the day in 2009 when my real estate guy was giving me a presentation and he said that China had 5.6 billion square meters of real estate under development, half residential and half commercial,” Chanos told me the other day.

“I said, ‘You must mean 5.6 billion square feet.’ ”

The man replied that he hadn’t misspoken; it really was 5.6 billion square meters, which amounted to over 60 billion square feet.

For Chanos, that is when the light bulb went on. The fast-growing Chinese economy was being sustained not just by its export prowess, but by a property bubble propelled by mountains of debt, and encouraged by the government as part of an infrastructure spending strategy designed to keep the economy humming. (According to the McKinsey Global Institute, China’s debt load today is an unfathomable $28 trillion.)

Chanos soon went public with his thesis, giving interviews to CNBC andCharlie Rose, and making a speech at Oxford University. He told Rose that property speculation in China was rampant, and that because so much of the economy depended on construction — in most cases building properties that had no chance of generating enough income to pay down the debt — China was on “the treadmill to hell.”

He also pointed out that much of the construction was for high-end condos that cost over $100,000, yet the average Chinese household made less than $10,000 a year.

Can you guess how the financial establishment, convinced that the Chinese juggernaut was unstoppable, reacted to Chanos’s contrarian thesis? It scoffed.

“I find it interesting that people who couldn’t spell China 10 years ago are now experts on China,” the well-known investor Jim Rogers told The New York Times. He added, “China is not in a bubble.”

The conventional view was that the Chinese economy would continue to grow at a rapid pace, and that Chinese officials, unencumbered by the messiness of democracy, could make quick adjustments if the economy started to slip.

Chanos was undeterred. “It reminded me of 1989, when everybody said that we should emulate the Japanese model,” he told me. “They used to say, ‘They can get stuff done and we can’t’ ” — just as the supposed experts were now saying about China.

As it turns out, China’s economy began to slow right around the time Chanos first made his call. No matter: Most China experts remained bullish. Chanos, meanwhile, was shorting the stocks of a number of companies that depended on the Chinese market. And he was regularly sending out emails when he came upon articles that seemed to confirm his thesis: stories about newly constructed ghost cities and troubled banks and debt-laden state-owned enterprises.

These days, with the markets in free-fall, it certainly looks like Chanos has been vindicated. China’s not the only reason the stock market has been so volatile, but it’s the most important one. China’s economy is faltering, its stock market is collapsing, and the ham-handed efforts by government officials to prop up both have mainly had the effect of disabusing anyone who still thinks the government can revive the economy with the snap of its fingers. This loss of confidence in China and its leaders has spooked stock markets around the world.

Snoopy-Typing-Away-1-CVV14J0D95-1024x768

China having a decline. Support around the $30 area. Wait and see.

Screen Shot 2015-07-09 at 7.43.42 AM

Next Page »