….Yet as the world’s second-largest economy continues to slog through the aftermath of its debt-driven economic miracle-cum-titanic housing bubble, policymakers put their best foot forward – with Chinese characteristics. Thus, aggregate financing fell by nearly RMB 200 billion in April from the prior month, data released over the weekend show, marking the first outright contraction in that metric of broad credit availability in nearly two decades.
True to form, the government looks to sweep those inconvenient figures under the rug, as Bloomberg relays that seven separate research notes from local brokerages commenting on that data release were scrubbed from the WeChat social media platform as of this morning.
Then, too, regulators have switched off live trading data showing foreign investment flows on the mainland Shanghai and Shenzhen exchanges via the Stock Connect trading link. That move, which was telegraphed in an April announcement, follows word that foreign direct investment registered at just $10.3 billion during the first quarter, down 56% from the first three months of 2023.
~ Jim Grant, Grant’s Almost Daily
Why China’s efforts to resolve hidden government debt could fall short | Caixin Global
Local governments make extensive use of local government finance vehicles (LGFVs) to conceal debt and present a healthy balance sheet. The hidden debt presents a major risk for central government as the economy threatens a debt-deflation spiral.
From Caixin Global, March 14 2024:
China’s central government has rolled out a new round of measures since the second half of last year to help local governments swap or restructure their off-the-books borrowing in a bid to control debt risk.
However, the sheer scale of the country’s local government hidden debt — up to more than 70 trillion yuan ($9.8 trillion) according to some estimates, more than twice Germany’s GDP — means that the measures at best are far inadequate and will provide only temporary relief to what experts say is a looming liquidity crisis for regional authorities….
Eleven reasons for optimism in the next decade
This might seem more like a wish list than a forecast — there are always risks that can derail predictions — but we believe these are high probability events over the long-term.
Our timeline is flexible, some events may take longer than a decade while others could occur a lot sooner.
Also, some of the reasons for optimism present both a problem and an opportunity. It depends on which side of the trade you are on.
#1 US Politics
The political divide in the United States is expected to heal after neither President Biden nor his predecessor, and current GOP front-runner Donald Trump, make the ballot in 2024. The first due to concerns over his age and the latter due to legal woes and inability to garner support from the center. A younger, more moderate candidate from the right (Nikki Haley) or left (Gavin Newsom?) is likely to be elected in 2024 and lead the reconciliation process, allowing Congress to focus on long-term challenges rather than political grandstanding.
Nikki Haley & Gavin Newsom – Wikipedia
#2 The Rise of Europe
Prime Minister of Estonia, Kaja Kallas – Wikipedia
Europe is expected to rediscover its backbone, led by the example of Eastern European leaders who have long understood the existential threat posed by Russian encroachment. Increased funding and supply of arms to Ukraine will sustain their beleaguered ally. NATO will re-arm, securing its Eastern border but is unlikely to be drawn into a war with Russia.
#3 Decline of the Autocrats
We are past peak-autocrat — when Vladimir Putin announced Russia’s full-scale invasion of Ukraine on February 23, 2022.
Vladimir Putin announces invasion of Ukraine – CNN
Russia
The Russian economy is likely to be drained by the on-going war in Ukraine, with drone attacks on energy infrastructure bleeding Russia’s economy. Demands on the civilian population are expected to rise as oil and gas revenues dwindle.
Fire at an oil storage depot in Klintsy, southern Russia after it was hit by a Ukrainian drone – BBC
China
The CCP’s tenuous hold on power faces three critical challenges. First, an ageing population fueled by the CPP’s disastrous one-child policy (1979-2015) and declining birth rates after the 2020 COVID pandemic — a reaction to totalitarian shutdowns for political ends.
Second, is the middle-income trap. Failure to overcome the political challenges of redistributing income away from local governments, state-owned enterprises and existing elites will prevent the rise of a consumer economy driven by strong levels of consumption and lower savings by the broad population.
Third, the inevitable demise of autocratic regimes because of their rigidity and inability to adapt to a changing world. Autocratic leaders grow increasingly isolated in an information silo, where subordinates are afraid to convey bad news and instead tell leaders what they want to hear. Poor feedback and doubling down on past failures destroy morale and trust in leadership, leading to a dysfunctional economy.
Iran
Iranian Ayatollah Ali Khamenei – Wikipedia
Demographics are likely to triumph in Iran, with the ageing religious conservatives losing power as their numbers dwindle. The rise of a more moderate, Westernized younger generation is expected to lead to the decline of Iranian-backed extremism and greater stability in the Middle East.
#4 High Inflation
The US federal government is likely to avoid default on its $34 trillion debt, using high inflation to shrink the debt in real terms and boost GDP at the same time.
#5 Negative real interest rates
High inflation and rising nominal Treasury yields would threaten the ability of Treasury to service interest costs on outstanding debt without deficits spiraling out of control. The Fed will be forced to suppress interest rates to save the Treasury market, further fueling high inflation. Negative real interest rates will drive up prices of real assets.
#6 US Dollar
The US Dollar will decline as the US on-shores critical industries and the current account deficit shrinks. Manufacturing jobs are expected to rise as a result — through import substitution and increased exports.
#7 US Treasury Market
USTs are expected to decline as the global reserve asset, motivated by long-term negative real interest rates and shrinking current account deficits.
Central bank holdings of Gold and commodities are likely to increase as distrust of fiat currencies grows, with no obvious successor to US hegemony.
#7 Nuclear Power
Investment in nuclear power is expected to skyrocket as it is recognized as the only viable long-term alternative to base-load power generated by fossil fuels. Reactors will be primarily fueled by coated uranium fuels (TRISO) that remove the risk of a critical meltdown.
TRISO particles consist of a uranium, carbon and oxygen fuel kernel encapsulated by three layers of carbon- and ceramic-based materials that prevent the release of radioactive fission products – Energy.gov
Thorium salts are an alternative but the technology lags a long way behind uranium reactors. Nuclear fusion is a wild card, with accelerated development likely as AI is used to solve some of the remaining technological challenges.
#8 Artificial Intelligence (AI)
Scientific advances achieved with the use of AI are expected to be at the forefront in engineering and medicine, while broad productivity gains are likely as implementation of AI applications grows.
#9 Semiconductors
Demand for semiconductors and micro-processor is likely to grow as intelligent devices become the norm across everything from electric vehicles to houses, appliances and devices.
#10 Industrial Commodities
Demand for industrial commodities — lithium, copper, cobalt, graphite, battery-grade nickel, and rare earth elements like neodymium (used in high-power magnets) — are expected to skyrocket as the critical materials content of EVs and other sophisticated devices grows.
Expected supply shortfall by 2030:
Prices will boom as demand grows, increases in supply necessitate higher marginal costs, and inflation soars.
#11 Stock Market Boom
Stocks are expected to boom, fueled by negative real interest rates, high inflation and productivity gains from AI and nuclear.
#12 Save 50% on a New Subscription
Conclusion
There is no cause for complacency — many challenges and pitfalls face developed economies. But we so often focus on the threats that it is easy to lose sight of the fact that the glass is more than half full.
Our long-term strategy is overweight on real assets — stocks, Gold, commodities and industrial real estate — and underweight long duration financial assets like USTs.
Acknowledgements
- World Politics Review, Alexander Clarkson: In Russia and Iran, External Aggression Masks Internal Vulnerabilities
- McKinsey: The semiconductor decade, A trillion-dollar industry
- ZeroHedge: Skyrocketing Battery Mineral Demand Set to Outpace Supply By 2023, February 14, 2024
- Wikipedia: China’s One-Child Policy
ASX 200 tests support
The ASX 200 retreated from resistance at the high of 7600 and is now testing support at 7400. Breach would warn of a correction to test primary support at 6750.
The Financials Index has similarly retreated from resistance at 6800. Reversal below 6650 would warn of a correction.
The A-REIT Index would likewise warn of a correction to test 1200 if support at 1440 is breached. The recent rally was in response to falling long-term bond yields.
The correction in yields is secondary in nature and is unlikely to reverse the long-term up-trend. Further increases in long-term yields are expected to weaken A-REITs.
Healthcare also rallied strongly in the past two months but could reverse if long-term bond yields strengthen.
Consumer Staples are in a strong down-trend. Breach of support at 11500 would warn of another decline.
Discretionary has surprised to the upside, breaking resistance at 3200. A Trend Index trough at zero indicates buying pressure. Retracement that respects the new support level would signal a further advance.
Energy rallied to test resistance at 11000 but a Trend Index peak below zero warns of selling pressure. Another test of primary support at 10000 is likely.
The All Ordinaries Gold Index fell sharply as the US Dollar strengthened. Follow-through below 6500 would warn of another test of support at 6000.
The ASX 300 Metals & Mining Index is falling sharply as China’s recovery falters. Another test of primary support at 5600 is likely.
China
Rate cuts and measures to stimulate the Chinese economy have been modest as the PBOC is trying to protect the Yuan from further depreciation against the US Dollar.
The result is slowing growth and deflation as weak demand persists.
Conclusion
Falling long-term bond yields have boosted Financials, REITs, Health Care and Consumer Discretionary sectors but the correction in yields is secondary and we expect this to reverse in 2024.
The Metals & Mining sector is falling sharply as China struggles to overcome weak demand while at the same time protecting the Yuan from further depreciation against the Dollar.
Our overall outlook for the ASX 200 remains bearish. Breach of support at 7400 would warn of a correction to test primary support from the October 2022 low at 6750.
Our 2023 Outlook
This is our last newsletter for the year, where we take the opportunity to map out what we see as the major risks and opportunities facing investors in the year ahead.
US Economy
The Fed has been hiking interest rates since March this year, but real retail sales remain well above their pre-pandemic trend (dotted line below) and show no signs of slowing.
Retail sales are even rising strongly against disposable personal income, with consumers running up credit and digging into savings.
The Fed wants to reduce demand in order to reduce inflationary pressure on consumer prices but consumers continue to spend. Household net worth has soared — from massive expansion of home and stock prices, fueled by cheap debt, and growing savings boosted by government stimulus during the pandemic. The ratio of household net worth to disposable personal income has climbed more than 40% since the global financial crisis — from 5.5 to 7.7.
At the same time, unemployment (3.7%) has fallen close to record lows, increasing inflationary pressures as employers compete for scarce labor.
Real Growth
Hours worked contracted by an estimated 0.12% in November (-1.44% annualized).
But annual growth rates for real GDP growth (1.9%) and hours worked (2.1%) remain positive.
Heavy truck sales are also a solid 40,700 units per month (seasonally adjusted). Truck sales normally contract ahead of recessions, marked by light gray bars below, providing a reliable indicator of economic growth. Sales below 35,000 units per month would be bearish.
Inflation & Interest Rates
The underlying reason for the economy’s resilience is the massive expansion in the money supply (M2 excluding time deposits) relative to GDP, after the 2008 global financial crisis, doubling from earlier highs at 0.4 to the current ratio of 0.84. Excessive liquidity helped to suppress interest rates and balloon asset prices, with too much money chasing scarce investment opportunities. In the hunt for yield, investors became blind to risk.
Suppression of interest rates caused the yield on lowest investment grade corporate bonds (Baa) to decline below CPI. A dangerous precedent, last witnessed in the 1970s, negative real rates led to a massive spike in inflation. Former Fed Chairman, Paul Volcker, had to hike the Fed funds rate above 19.0%, crashing the economy, in order to tame inflation.
The current Fed chair, Jerome Powell, is doing his best to imitate Volcker, hiking rates steeply after a late start. Treasury yields have inverted, with the 1-year yield (4.65%) above the 2-year (4.23%), reflecting bond market expectations that the Fed will soon be forced to cut rates.
A negative yield curve, indicated by the 10-year/3-month spread below zero, warns that the US economy will go into recession in 2023. Our most reliable indicator, the yield spread has inverted (red rings below) before every recession declared by the NBER since 1960*.
Bear in mind that the yield curve normally inverts 6 to 18 months ahead of a recession and recovers shortly before the recession starts, when the Fed cuts interest rates.
Home Prices
Mortgage rates jumped steeply as the Fed hiked rates and started to withdraw liquidity from financial markets. The sharp rise signals the end of the 40-year bull market fueled by cheap debt. Rising inflation has put the Fed on notice that the honeymoon is over. Deflationary pressures from globalization can no longer be relied on to offset inflationary pressures from expansionary monetary policy.
Home prices have started to decline but have a long way to fall to their 2006 peak (of 184.6) that preceded the global financial crisis.
Stocks
The S&P 500 is edging lower, with negative 100-day Momentum signaling a bear market, but there is little sign of panic, with frequent rallies testing the descending trendline.
Bond market expectations of an early pivot has kept long-term yields low and supported stock prices. 10-Year Treasury yields at 3.44% are almost 100 basis points below the Fed funds target range of 4.25% to 4.50%. Gradual withdrawals of liquidity (QT) by the Fed have so far failed to dent bond market optimism.
Treasuries & the Bond Market
Declining GDP is expected to shrink tax receipts, while interest servicing costs on existing fiscal debt are rising, causing the federal deficit to balloon to between $2.5 and $5.0 trillion according to macro/bond specialist Luke Gromen.
With foreign demand for Treasuries shrinking, and the Fed running down its balance sheet, the only remaining market for Treasuries is commercial banks and the private sector. Strong Treasury issuance is likely to increase upward pressure on yields, to attract investors. The inflow into bonds is likely to be funded by an outflow from stocks, accelerating their decline.
Energy
Brent crude prices fell below $80 per barrel, despite slowing releases from the US strategic petroleum reserve (SPR). Demand remains soft despite China’s relaxation of their zero-COVID policy — which some expected to accelerate their economic recovery.
European natural gas inventories are near full, causing a sharp fall in prices. But prices remain high compared to their long-term average, fueling inflation and an economic contraction.
Europe
European GDP growth is slowing, while inflation has soared, causing negative real GDP growth and a likely recession.
Australia, Base Metals & Iron Ore
Base metals rallied on optimism over China’s reopening from lockdowns. Normally a bullish sign for the global economy, breakout above resistance at 175 was short-lived, warning of a bull trap.
Iron ore posted a similar rally, from $80 to $110 per tonne, but is also likely to retreat.
The ASX benefited from the China rally, with the ASX 200 breaking resistance at 7100 to complete a double-bottom reversal. Now the index is retracing to test its new support level. Breach of 7000 would warn of another test of primary support at 6400.
China
Optimism over China’s reopening may be premature. Residential property prices continue to fall.
The reopening also risks a massive COVID exit-wave, against an under-prepared population, when restrictions are relaxed.
“In my memory, I have never seen such a challenge to the Chinese health-care system,” Xi Chen, a Yale University global health researcher, told National Public Radio in America this week. With less than four intensive care beds for every 100,000 people and millions of unvaccinated or partially protected older adults, the risks are real.
With official data highly unreliable, it is hard to track exactly what impact China’s U-turn is having. Authorities on Friday reported the first Covid-19 deaths since most restrictions were lifted in early December, but there have been reports that funeral homes in Beijing are struggling to handle the number of bodies being brought in.
“The risk factors are there: eight million people are essentially not vaccinated,” said Huang Yanzhong, senior fellow for global health at the Council on Foreign Relations.
“Unless this variant has evolved in a way that makes it harmless, China can’t avoid what happened in Taiwan or in Hong Kong,” he added, referring to significant “exit waves” in both places.
The scale of the surge is unlikely to be apparent for months, but modelling suggests it could be grim. A report from the University of Hong Kong released on Thursday warned that a best case scenario is 700,000 fatalities – forecasts from a UK-based analytics firm put deaths at between 1.3 and 2.1 million.
“We’re still at a very early stage in this particular exit wave,” said Prof Ben Cowling, an epidemiologist at the University of Hong Kong. (The Telegraph)
China relied on infrastructure spending to get them out of past economic contractions but debt levels are now too high for stimulus on a similar scale to 2008. Expansion of credit to local government and real estate developers is likely to cause further stagnation, with the rise of zombie banking and real estate sectors — as Japan experienced for more than three decades — suffocating future growth.
Conclusion
Resilient consumer spending, high household net worth, and a tight labor market all make the Fed’s job difficult. If the current trend continues, the Fed will be forced to hike interest rates higher than the bond market expects, in order to curb demand and tame inflation.
Expected contraction of European and Chinese economies, combined with rate hikes in the US, are likely to cause a global recession.
There are two possible exits. First, if central banks stick to their guns and hold interest rates higher for longer, a major and extended economic contraction is almost inevitable. While inflation may be tamed, the global economy is likely to take years to recover.
The second option is for central banks to raise inflation targets and suppress long-term interest rates in order to create a soft landing. High inflation and negative real interest rates may prolong the period of low growth but negative real rates would rescue the G7 from precarious debt levels that have ensnared them over the past decade. A similar strategy was successfully employed after WWII to extricate governments from high debt levels relative to GDP.
As to which option will be chosen is a matter of political will. The easier second option is therefore more likely, as politicians tend to follow the line of least resistance.
We have refrained from weighing in on the likely outcome of the Russia-Ukraine conflict. Ukraine presently has the upper hand but the conflict is a wild card that could cause a spike in energy prices if it escalates or a positive boost to the European economy in the unlikely event that peace breaks out.
Our strategy is to remain overweight in gold, critical materials, defensive stocks and cash, while underweight bonds and high-multiple technology stocks. In the longer term, we will seek to invest cash in real assets when the opportunity presents itself.
Acknowledgements
- Hat tip to Macrobusiness for the Pantheon Macroeconomics (China Residential) and Goldman Sachs (China Local Government Funding & Excavator Hours) charts.
Notes
* The yield curve inverted ahead of a 25% fall in the Dow in 1966. The NBER declared a recession but later changed their minds and airbrushed it out of their records.
The globalization trap
On March 8, 2000, President Bill Clinton made a persuasive pitch to Washington’s foreign policy elite, Congress and the international community, on the merits of China’s accession to the World Trade Organization:
“Membership in the WTO, of course, will not create a free society in China overnight or guarantee that China will play by global rules. But over time, I believe it will move China faster and further in the right direction……..We have a far greater chance of having a positive influence on China’s actions if we welcome China into the world community instead of shutting it out.”
That was little more than a decade after the Beijing government massacred thousands of students participating in pro-democracy demonstrations in Tiananmen Square, June 1989. Twenty years have passed since China’s 2002 accession to the World Trade Organization. Let’s review how that is working out.
Zero progress toward a free society
Xi Jinping reversed any progress, towards a more open society, made under Hu Jintao. Xi revoked the term limit on his leadership as General Secretary of the Chinese Communist Party; increased censorship and mass surveillance; imprisoned minorities; suppressed news of the COVID outbreak in early 2020, causing a global pandemic; he shredded the one-country-two-systems agreement with the UK and cracked down on the pro-democracy movement in Hong Kong; while threatening democratic Taiwan with invasion.
Malign influence on democratic institutions
Rather than opening up China to Western influence, an open Western society proved highly susceptible to Chinese influence operations. Efforts to suppress free speech include infiltration of universities through establishment of Confucius Institutes and research grants; the Belt-and-Road initiative to increase control over fledgling democracies in the Asia-Pacific and Africa; and growing control over appointments in UN bodies. North Korea, for example, has been appointed as the current Chair of the UN Conference on Nuclear Disarmament.
Growing geopolitical challenge
Trade with the West has empowered China’s development of a powerful nuclear ICBM force, including hypersonic weapons; seizure and militarization of disputed shoals in the South China Sea, flouting international conventions; and development of a blue-water navy to expand its influence far beyond its shores.
Negative economic impact on the US.
Ignore the flowery speeches about democracy and freedom from the former President, the primary purpose of China’s admission was to enrich US corporations. When President Clinton described China’s admission as a “win-win”, you can be sure that US multinationals understood this to mean increased profit margins and new markets. China was also meant to benefit economically, to the extent that workers’ standard of living would need to rise so that they could consume more mass-produced Western goods.
It didn’t work out as planned.
Corporate profit margins rose to new highs, post-2002, as employee compensation fell.
The price was destruction of millions of manufacturing jobs as US companies shifted factories to Asia, where labor costs were a fraction of those in the US. Initially the erosion started with low-skill, menial jobs but soon expanded to high technology sectors as China’s industrial base grew.
Industrial production in the US stalled after the 2008 crash, losing an entire decade of growth.
Current account deficits ballooned as Chinese exports flowed into the US, supported by massive capital outflows from China to maintain their currency peg against the US Dollar. Capital outflows prevented the Yuan from appreciating against the Dollar — which would have eroded China’s pricing advantage in international markets.
The US slipped from being a net creditor in the 1980s to the world’s biggest debtor, with a negative net international investment position (NIIP) of more than $18 trillion.
Federal debt climbed to a precarious 128% of GDP in 2021 as the government ran ever-larger deficits to support the economy and offset the massive current account hemorrhage.
The traditional relationship between government deficits and unemployment started to break down in the late 1980s. Unemployment (RHS) is on an inverted scale below, so high unemployment is near the bottom and low figures are near the top of the chart. Before the late 1980s, deficits were relatively small , increasing to between 4% and 6% of GDP when unemployment spiked during a recession. But deficits were kept close to 3% of GDP in the Reagan-Bush (HW) era, even when employment had recovered (blue circle). The hoped-for boost to GDP failed to materialize but the experiment was nevertheless repeated, even more aggressively, by Trump in 2016-2020, cutting corporate taxes in the hope that this would boost growth. But GDP growth again remained low.
The Fed started expanding its balance sheet after the 2008 global financial crisis, in order to support a massive fiscal deficit of 10% of GDP, and an even larger 15% deficit in 2020. The effect was self-reinforcing as QE discouraged foreign investors from purchasing Treasuries — out of fear that the Dollar was being debased — forcing the Fed to inject ever-larger amounts of QE to make up for the absence of foreign funding. Money supply (M2) spiked upwards as a percentage of GDP, adding to debasement fears.
There was one win, however, from globalization that the Fed was quick to claim. Low inflation is mistakenly attributed to Fed skill in managing the economy rather than the real reason: erosion of the US industrial base which undermined wages growth, particularly in the manufacturing sector.
Conclusion
Admission of China to the World Trade Organization in 2002 was an unmitigated disaster, unleashing a massive deflationary shock that destabilized the global financial system. Despite being a developing economy, China become a major exporter of capital, as well as goods, upsetting the level playing field of international exchange rates. This helped to suppress the Yuan, giving Chinese manufacturers an advantage over Western competitors, and caused the loss of millions of manufacturing jobs in the West. The Western response was to run larger deficits, causing public debt to balloon to precarious levels, while central banks efforts to support growing fiscal debt destabilized the global financial system.
The recent surge in inflation exposed central banks inability to protect their currencies, without causing a global recession, undermined by precarious public debt levels and bloated central bank balance sheets.
Sir James Goldsmith — interviewed here in 1994 by Charlie Rose — was on the money when he referred to breach of the social contract between capital and labor, that ensured political stability in the West, and the betrayal of trust between political leaders and their electorate.
The present course is unsustainable in the long run and we anticipate an era of de-globalization as nations on-shore critical supply chains. There is no other currency that can compete with the Dollar’s status as global reserve currency but the system is likely to evolve towards a multi-polar world, with several separate trading/currency systems backed by commodities such as Gold, Silver and Base Metals. Oil would be ideal, as energy is central to the global economy, but storage is cumbersome; so a fixed exchange rate between oil and gold/base metals is more likely.
Deconstructing Evergrande’s effect on China
Elliot Clarke at Westpac says that China will be able to withstand the shock of Evergrande’s collapse and that power outages are a bigger threat.
We still think that the property sector contagion is part of a broader issue that China will struggle to overcome, as Michael Pettis succinctly explained:
China’s debt problem
Tweeted by Prof. Michael Pettis:
In the past — e.g. the SOE reforms of the 1990s, the banking crisis of the 2000s, SARS in 2003, the collapse of China’s trade surplus in 2009, COVID, etc. — whenever China faced a problem that threatened the pace of its economic growth, Beijing always responded by accelerating debt creation and pumping up property and infrastructure investment by enough to maintain targeted GDP growth rates. It didn’t adjust, in other words, but rather goosed growth by exacerbating the underlying imbalances.
That is why it had always been “successful” in seeing off a crisis. But when the main problem threatening further growth becomes soaring debt and the sheer amount of non-productive investment in property and infrastructure, it is obvious, or should be, that accelerating debt creation and pumping up property and infrastructure investment can no longer be a sustainable solution. All this can do is worsen the underlying imbalances and raise further the future cost of adjustment.
What would Putin do?
The Communist Party of China has an unwritten contract with the 1.4 billion people living under its rule: they will tolerate living under an autocratic regime provided that the CCP delivers economic prosperity. So far the CCP has delivered in spades. A never-ending economic boom, fueled by exponential debt growth as investment in productive infrastructure grows ever more challenging.
But they are now familiar with the law of diminishing marginal returns: governments can’t just keep spending on infrastructure without falling into a debt trap. All the low-hanging fruit have been picked and new infrastructure projects offer lower and lower returns as spending programs continue.
That was probably the primary motivation for the CCP’s Belt-and-Road Initiative (BRI): to source more productive infrastructure investments in international markets. But the COVID-19 pandemic brought the BRI to a shuddering halt and the CCP is unlikely to maintain its exemplary growth record — no matter how much they fudge the numbers.
Xi Jinping is faced with an impossible task: how to placate 1.4 billion people when inflation sends food prices soaring and ballooning debt precipitates a sharp rise in unemployment and falling wages. The CCP has been preparing for this very eventuality for some time. Investing billions in surveillance and social credit systems, brutal crackdowns on religious organizations and minorities, suppression of democratic forces in Hong Kong, the latest take-down of tech giants — Jack Ma’s Ant Group and Tencent Holdings — which could form a focal point for democratic opposition, and beefing up internal policing. These are not the whims of an autocratic regime but a desperate attempt at self-preservation. China’s internal security budget is even bigger than its military budget (WION).
Behind that inscrutable facade, Xi Jinping is a worried man. Even with all the technology and forces of suppression at his disposal, confronting an angry population of 1.4 billion people is a daunting task. In his darkest hours he must have asked himself the question: WHAT WOULD PUTIN DO?
Even if you don’t believe the RT hype of the bare-chested deer hunter, judo expert and chess grandmaster — a combination of Chuck Norris and Garry Kasparov — you have to give Vladimir Putin credit for surviving 20 years as the head of a murderous regime where only the strong and completely ruthless stay alive.
What would Putin do? The answer must have hit Xi Jinping like a 500 watt light bulb: INVADE CRIMEA. Vladimir Putin enjoyed record popularity at home (if you can believe Russian opinion polls) after invading Crimea. Despite the economic hardships that the Russian people had to endure from Western sanctions. The only force more powerful than hunger is a wave of patriotic nationalism.
Now being the canny fellow that he is, Xi figured that Crimea was too far away to be much use. Luckily for him, there is a handy substitute. An island of 23.5 million inhabitants, living under a democratically-elected government, only 180 kilometers away, across the Taiwan Strait.
Conclusion
We expect the CCP to fuel a wave of nationalist fervor to distract the 1.4 billion people living under their harsh rule from the economic hardships they are about to endure. Conflict over Taiwan is an obvious choice.
At present the PLA is conducting daily incursions into Taiwanese airspace, to map ROC air defense systems and wear down defenders with “response fatigue”.
The CCP would not want to interfere with the Beijing Winter Olympics but may use it as a distraction — straight out of Putin’s playbook.
Melik Kaylan at Forbes:
I can say one thing about Vladimir Putin without fear of contradiction: he cares about timing. When he’s up to no good, he loves a sleight-of-hand distraction in global headlines. In 2008 [invasion of Georgia], the Beijing summer Olympics served as cover. More recently, the Sochi Winter Olympics ended just three days before Russia marched into Crimea.
Notes
- The 2022 Winter Olympics — also known as Beijing 2022 — is scheduled to take place from 4 to 20 February 2022.
The Coronavirus Threat
Spread of the novel coronavirus (2019-nCoV) is a “global health emergency” according to the World Health Organization (WHO). Restricted travel is already having an impact on the global economy, with Goldman Sachs anticipating a 0.4% fall in U.S. annualized GDP growth in the first quarter.
Imperial College in London estimates a dangerously high transmission rate for the disease:
Self-sustaining human-to-human transmission of the novel coronavirus (2019-nCov) is the only plausible explanation of the scale of the outbreak in Wuhan. We estimate that, on average, each case infected 2.6 (uncertainty range: 1.5-3.5) other people up to 18th January 2020, based on an analysis combining our past estimates of the size of the outbreak in Wuhan with computational modelling of potential epidemic trajectories. This implies that control measures need to block well over 60% of transmission to be effective in controlling the outbreak….
Johns Hopkins University CSSE reports 11,374 confirmed cases with 259 deaths and 252 recoveries as of 7.00 p.m. on January 31, 2020. Growth of the number of reported cases in Mainland China appears linear, with an increase of 1,700 per day.
That seems highly suspicious when one compares to mathematical modeling and to social media reports from medical staff on the ground. Contagion rates are likely to grow exponentially, rather than in a straight line, and will only peak when authorities are able to bring the transmission rate below 1.0 (compared to the 2.6 posited by Imperial College).
A report in the Epoch Times suggests that Chinese public health authorities have suppressed the reporting of confirmed cases:
“The outbreak of Wuhan coronavirus is far bigger than the official figures released by Chinese public health authorities who cover up the severity by limiting the number of diagnosis kits to Wuhan hospitals, according to an insider and an independent journalist.
The insider and the independent journalist both say that diagnosis kits are only provided to certain ‘qualifying hospitals’ and in very limited quantities. Medical personnel at these hospitals have said that the number of kits they are supplied is less than 10 percent of what they need to test patients.
Now these hospitals claim that their responsibility at present is to provide treatment only, and they will not perform any diagnoses.”
UK researcher Jonathan Read projects that the epidemic in Wuhan will reach 191,529 by February 4 (prediction interval 132,751-273,649). Chart A shows total number of infections in black and new infections per day in red.
Restriction of road, rail and air travel to/from Wuhan is expected to achieve between 12.5% and 25% reduction in cases in the above areas.
Importations into other countries may also be slowed by travel restrictions.
Mortalities are not limited to young children and the elderly and infirm as with most influenza viruses. Healthy adults, including health care workers, are dying. Reported recoveries (252) are low and provide an indication as to the severity of the infection.
Modelling suggests that the number of cases will double every seven days until it peaks. The peak number of cases will depend on how long it takes to contain the outbreak. Another four weeks would pose a serious threat to the global economy.
Where Fortune is concerned: she shows her force where there is no organized strength to resist her; and she directs her impact there where she knows that no dikes and embankments are constructed to hold her. ~ Niccolo Machiavelli, The Prince (1532)
Cracks are showing in China’s Debt Markets
“You only learn who has been swimming naked when the tide goes out…” ~ Warren Buffett
Beijing’s de-leveraging campaign, to set the economy on a sustainable path, is starting to expose some of the excesses in financial markets.
Local Government
Local governments owe some 49 trillion yuan (about $7 trillion or 50% of China’s GDP) in off-balance-sheet debt through local government finance vehicles (LGFVs). LGFVs generate no income themselves and are reliant on revenue flows from the city government to service the debt. Local governments in the past generated substantial revenue through land sales but dwindling sales make debt servicing a challenge. Many LGFVs are experiencing cash flow problems and have resorted to borrowing in shadow finance markets to meet their commitments. Interest rates are close to 10% and will simply accelerate the inevitable implosion.
This map from Rhodium highlights the most severely affected LGFVs, where debt in some cases exceeds 30 times local government revenues:
China’s Ministry of Finance (MOF) is attempting to keep a lid on the problem, offering long-term low interest loans from China Development Bank to repay shadow financing. Zhenjiang, an eastern city of Jiangsu province was one of the first beneficiaries, in March 2019. But debt substitution merely prolongs the crisis unless the city can sell off marketable assets to repay debt. Marketable assets which are, in many cases, proving hard to find.
This detailed report from Rhodium examines the problem.
State-owned Enterprises (SOEs)
We are also witnessing a $1.25 billion default by local government-owned Tewoo Group:
“China’s Tewoo Group has forced investors to take losses on a US dollar bond, marking the largest failure to repay dollar debt by a state-owned company in two decades….The commodities trader, which is wholly owned by the city government of Tianjin, completed an exchange offer this week that made investors take significant discounts on their holdings in the company’s debt.”
“The offer was ‘tantamount to a default’, S&P Global Ratings said on Thursday.” ~ FT.com
Based out of Tianjin, Tewoo is a bulk trader of commodities such as metals (ferrous & nonferrous), energy, minerals and chemicals….
In 2017, it had a turnover of $66.6 billion with profits of $122 million and was ranked 129th in the Fortune Global 500 list & 28th in the Chinese enterprises list. The company employs more than 19,000 professionals and has operations across the US, Germany, Japan and Singapore.
Tewoo’s financial challenges are closely linked to Bohai Steel Group, a business associate which has filed for liquidation due to high leverage. Bohai’s bankruptcy in 2018 triggered systemic risk in Tianjin’s financial market and Tewoo has been facing serious liquidity challenges in recent months. ~ MoneyControl
Bank Bailouts
Many small and medium-sized banks are overly reliant on wholesale markets for funding and tightening credit has left them high and dry.
Barclays Research highlighted a number of banks that had failed to submit their 2018 annual reports on time (source Zero Hedge/Macrobusiness):
- Baoshang Bank underwent a state takeover in May.
- Bank of Jinzhou was taken over by state-owned strategic investors in July.
- Heng Feng Bank was taken over by China’s sovereign wealth fund in August.
- Troubled Anbang Insurance Group is selling a 35% stake in Chengdu Rural Commercial Bank to “an investment firm owned by the southwestern city of Chengdu.” (Caixin)
While, according to Caixin:
“China’s Hengfeng Bank will raise 100 billion yuan ($14.21 billion) through a private placement to a group of state and foreign investors…..The troubled Shandong-based lender will issue 100 billion shares, Hengfeng said Wednesday in a statement.”
Foreign investment is simply window-dressing, with Singapore’s United Overseas Bank subscribing for 4% of the new issue. Probably with a “put” on the other state-owned purchasers.
“The bailouts for China’s troubled small banks roll on……China’s sneaky system-wide bank bailout is well underway.” ~ Trivium China
Efforts by Beijing to curb exponential debt growth are praiseworthy, but are likely to come at a substantial cost. Expect GDP growth to slow and gradual “Japanification” as the state attempts to avoid hard choices, supporting the continued existence of “zombie” companies ……and sclerosis of the Chinese economy.