China's Miracle Economy is Nothing More Than Fool's Gold
6 FEBRUARY 2017
Don't read the first few paragraphs of today's Daily Reckoning if you intend on watching Matthew McConaughey's new movie, Gold.
Gold is based on the Bre-X mining scandal of the mid-1990s.
The names, dates and locations have been changed to protect the not-so-innocent.
The scam was a simple one. A geologist 'salted' the core samples with gold shavings from his wedding ring. When his wedding ring had been reduced to dust, he bought panned gold from the locals...enabling the fraud to continue for a few years.
At its peak, the once penny-dreadful Bre-X was valued at US$6 billion.
In the movie, McConaughey's character is questioned over the fraud. He says, to the effect of: 'No one wanted to look too deeply at the operation. Everyone was making money, so they turn a blind eye.'
Getting wisdom after the fact always leaves you poorer for the experience.
Believing the hype - US stock markets making record highs; Australia's property market being 'different'; loss-making tech companies being valued in the billions based on the number of 'eyeballs'; and China's miracle economy - without applying any critical judgement only works while there is a bigger fool to buy into the story.
Once the less-than-solid foundations supporting the story are exposed - as they inevitably will be - the 'proverbial' hits the fan, as investors scramble for the exits. Too late.
When I heard McConaughey's explanation, it reminded me of China's miracle economy.
China's economic core samples are 'salted' with large doses of debt and state-mandated 'growth'.
But very few really question the sustainability of China's debt-fuelled growth model.
They're making too much money. It's far easier to look the other way and play the game.
The Chinese economic miracle
China's rapid development from rice paddies to booming metropolises has been widely referred to as an 'economic miracle' - a miracle that's been very beneficial to the Australian economy.
According to Google, the definition of 'miracle' is:
'...an exceptional product or achievement, or an outstanding example of something.'
There's no doubt that China's growth has been an exceptional achievement. However, that growth has been a direct result of an outstanding example of credit expansion on steroids.
In October 2014, Martin Wolf wrote an article in The Financial Times titled: 'We are trapped in a cycle of credit booms'. He notes:
- 'Consider the past quarter century: a credit boom in Japan that collapsed after 1990; a credit boom in Asian emerging economies that collapsed in 1997; a credit boom in the north Atlantic economies that collapsed after 2007; and finally in China. Each is greeted as a new era of prosperity, to collapse into crisis and post-crisis malaise.'
China's 'miracle' was a product of a credit boom...but not your 'garden variety type' credit boom.
A McKinsey Global Institute report, 'Debt and (not much) Deleveraging', published in February 2015, provided the hard data on the extent of China's credit binge (emphasis mine):
- 'Global debt has grown by $57 trillion and no major economy has decreased its debt-to-GDP ratio since 2007. High government debt in advanced economies, mounting household debt, and the rapid rise of China's debt are areas of potential concern.'
China's debt has quadrupled since 2007. Fueled by real estate and shadow banking, China's total debt has nearly quadrupled, rising to $28 trillion by mid-2014, from $7 trillion in 2007.'
In the space of seven years (2007-2014), China's debt increased by a (pick your adjective) mammoth/gargantuan/eye-watering/ridiculous/irresponsible US$21 trillion. China alone accounted for roughly 40% of the total global debt accumulated over that period.
Little wonder Australia enjoyed a mining boom...that money had to go somewhere.
A quadrupling of debt still makes me shake my head in sheer disbelief.
We all know what's behind China's impressive growth numbers...a credit boom without peer. But what's interesting is that, in spite of the injection of US$21 trillion of debt into the system, there's a distinct downward trend in GDP growth since 2007.
Proving yet again that too much debt becomes a drag on the economy. Income that would have otherwise been used for production and/or consumption is diverted to loan repayments. It takes more and more debt to generate a dollar of economic growth.
This is the same problem all credit booms have encountered; they simply run out of capacity to keep the bubble inflated...the Achilles heel of all Ponzi schemes.
The $64,000 question
Does China's bubble get bigger, does the bubble deflate slowly, or does the bubble burst?
The bubble may get bigger, but that's only delaying its inevitable pop.
In the 'bubble bursting spectacularly' camp is Kyle Bass from Hayman Capital. In February 2016, he wrote (emphasis mine):
- 'The unwavering faith that the Chinese will somehow be able to successfully avoid anything more severe than a moderate economic slowdown by continuing to rely on the perpetual expansion of credit reminds us of the belief in 2006 that US home prices would never decline. Similar to the US banking system in its approach to the Global Financial Crisis ("GFC"), China's banking system has increasingly pursued excessive leverage, regulatory arbitrage, and irresponsible risk taking.
'China has allowed (and encouraged) its banking system to grow into a gargantuan $34 trillion behemoth (a whopping 340% of Chinese GDP). For context, consider what the United States banking system looked like going into the GFC of 2007-2009. On-balance sheet, the US banking system had about $1 trillion of equity and $16.5 trillion of banking system assets (100% of US GDP). If non-banks and off-balance sheet assets are included, it would add another $12.5 trillion to get to about 175% of GDP.'
China's banking system (as a percentage of GDP) has been given the official 'wink and nod' to expand to double the size of the overextended US banking system of 2007-09. That's frightening.
Kyle Bass believes China will follow the same well-trodden path of all those countries that have used excess leverage to 'grow' an economy...a banking system that collapses under the weight of bad debts.
The highly-respected Michael Pettis, Professor at Peking University's Guanghua School of Management, is of the opinion that China might be able to engineer a gradual deflation of its debt bubble.
In his excellent blog on 31 August 2016, Professor Pettis wrote (emphasis mine):
- 'Because debt itself is constraining growth - I expect it to force [China's] 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.'
Even in a best-case scenario, China's growth is expected to halve in the years ahead.
There are commentators who tell us 'China is different', and that it cannot be compared to other countries which have tried and failed in their attempts to produce stellar economic growth from excessive debt. We are told the Communist Party know what they are doing, and that it is well equipped to handle any financial shocks.
When China's share market plunged in June 2015, and again in January 2016, many thought this might be the beginning of the end for China's miracle. The authorities managed to steady the ship with an unprecedented level of intervention...a degree of calm was restored. However, the Shanghai stock exchange is still 40% below its June 2015 high.
The debt is still in the system; it hasn't gone away. As Michael Pettis wrote, '...the debt must be written down or paid down and its costs must be allocated.'
The authorities have bought time, but not a solution.
The Financial Times on 4 January 2017:
- '...few think that China's fundamental economic challenges> have been addressed. The relatively strong growth performance came at the cost of adding further leverage to the economy and falling back on smokestack industries to drive growth. Many economists believe that by pursuing overly ambitious short-term growth targets while delaying necessary but painful reforms, policymakers are only storing up trouble.
'"The basic problem is they've got a growth target that's unrealistic," says Jonathan Anderson, principal at Emerging Advisors Group in Shanghai and a former China head for the International Monetary Fund. "They [the leadership] are talking about, 'Instead of 6.5 per cent, let's go for maybe 6.2 or 6.1 per cent'. Well, that's nice, but you have to go from 6.5 to 3 per cent to knock this back," he adds, predicting that China will eventually suffer a financial crisis if leverage keeps rising at the current pace.
'China's total debt load had reached 255 per cent of GDP by the end of June, up from 141 per cent in 2008 and well above the average of 188 per cent for emerging markets, according to the Bank for International Settlements.'
China is charging headlong into the heavily-fortified wall of economic reality. The one that's graffitied with the words: There's no new way to go broke...it is always too much debt.
China can continue pumping high-octane debt fuel into its economic engine and risk a high impact collision OR it can take its foot off the pedal and accept that it's going to hit the wall with slightly less force.
Since 2008, we've lived in a fool's paradise...one created by officially-sanctioned policies - from all corners of the world - with the sole purpose of creating the wealth effect.
Manipulation has (temporarily) replaced market pricing.
But eventually markets always win...they never lose.
Those in on the Bre-X scam took their money off the table before the fraud was exposed to the market.
My recommendation is to take profits from the biggest scam in history - the one that's made people believe you can create lasting wealth from printing money and bingeing on cheap debt.
Those who continue turning a blind eye to this illusion will have their eyes opened wide when the con is revealed.
Act early. Turn your fool's gold into cold, hard cash while there are still bigger fools out there.
Please note: This article was first published in The Daily Reckoning Australia on February 06, 2017.
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