The Yellow Brick Road

The spectacular growth of Chinese economy in recent years (well above 10% of Y/Y GDP increase) is making the analysts to be very shy with any predictions that are not 100% rosy. Some famous hedge fund managers are making their kids to learn Chinese, others are competing with predictions when China will surpass US as a world biggest economy.

I think it can be attributed to well-known human brain feature to extend any trend ad infinitum, so to some extend I can say that possible trend reversal here is not only an economic event, but also a medical diagnosis for the forecasting community. Back in the 80s they used to predict that Japan will become the World biggest economy within few years. The clock is still ticking.

My task here is much simpler. I’m not here to demise a Great Chinese Empire but merely to make the case that foreign assets held by China are in great danger.

This fine article is making the case for the huge overcapacity of Chinese economy. Please read it in full, I need just few short excerpts:

Hong Kong companies may shut 20,000 factories in neighboring Guangdong Province in the Chinese mainland this year

We know that Chinese exports are slowing, but internal consumption is in danger as well:

China’s stockpile of unsold new vehicles rose about 50 percent in the six months ended June […]

China Southern Airlines Co. and the nation’s other carriers posted a 3.8 percent fall in combined passenger traffic last month, as an economic slowdown curbed demand for air-travel

As we learn that many factories have to be closed we need to examine what does in mean to build or shut-down a factory in China:

China, by contrast, has no rural property rights. China’s 750 million rural residents who lease land are at the mercy of the local and regional government as to what compensation they will receive, if any, when they are forced from the land as a result of development, infrastructure improvements, etc. Additionally they have no right to borrow against their lease, and as such they have no assets. In fact, the Chinese government’s official figures state that more than 200,000 hectares of rural land are taken from rural residents every year with little or no compensation.

So building every new factory is destroying the wealth of peasants that are converted into labor ants, with no property, no savings and no other income except the $3/day they get for whatever they do on this factory. What will happen if this factory is shut down?

The result is not unexpected, with over 87,000 mass incidents (or riots) reported in 2005, a 50% increase from 2003. Many provincial governments in China have begun to use plainclothes policemen to beat, intimidate, or otherwise subdue any peasant that dares to oppose these land grabs. And, as would be expected, the beneficiaries from these policies are developers and corrupt government officials.

87,000 riots in 2005. Do you have any data how many riots we had in US back in 2005? So the peasants are rioting when forced from the land into factories. Will they riot again if forced from the closed factory into nowhere? You bet they will.

I have no doubt that the good amount of Chinese economy is operating at loss. What is the capacity of the economy to withstand the downturn?

When economists are speaking about China financial strength they mention the $1.3-$1.8 trillion of the Central Bank reserves (depending on who’s counting). But I don’t hear too many talks about liabilities. This article says:

A Chinese Finance Ministry’s report in March noted that the central government had 5.21 trillion Yuan ($714.23 billion at the then-prevailing exchange rate) in debt at the end of 2007

But the article says that this debt is seriously understated. More:

In the Chinese economy, moreover, a large portion of gross domestic product — perhaps as much as a quarter — is attributable to the state’s fiscal stimulus. Much of this takes the form of seed money for local government projects, many explicitly or implicitly guaranteed by local authorities, although they’re not economically viable. In view of all this, local governments seem to be illicitly taking on obligations at about the pace of GDP growth

So the local budgets are taking unknown liabilities to artificially stimulate the production. I suppose they will take even more liabilities to unwind this production back.

Best estimates indicate that provinces and lower-tier governments have incurred unrecorded debt equal to roughly 10% of GDP. That brings the debt-to-GDP ratio to around 45%, still some distance from the international alarm level. China’s ratio doesn’t include still other obligations. There is, for instance, about a trillion dollars of nonperforming and questionable loans on the books of the Ministry of Finance, its instrumentalities and state banks. The national social security system is grossly underfunded, especially as Beijing continues to extend subsistence payments. These two items inflate China’s ratio to more than twice the 60% level.

But in the next Chinese downturn, which many expect after the Olympics, Beijing’s hidden obligations could trigger crisis at home and perhaps panic abroad. No developing nation has escaped a financial crash. So we may find out soon what happens when Beijing dumps a trillion dollars of foreign assets all at once to pay off its hidden obligations at home.

So let put it straight - China is facing the default on its debts and a possible financial collapse unless it dumps all its foreign reserves. All economists around are saying that Rimnimbi is undervalued, mostly due to artificial pegging policy. Let me play the devil advocate and say that Rimnimbi will be soon grossly overvalued. I do not exclude the possibility of the Yuan to lose 50% or more of its value against the dollar.

But the first thing to happen is China to dump its foreign assets. From this link we can learn that they hold $376 bln of Fannie and Freddie bonds. Those will go first, braking havoc in our mortgage market and forcing the Treasury to feed into that “unlimited” credit line GSEs are asking for. At first the process of dumping dollar-denominated assets will make Yuan even stronger, which will make some to think that Chinese economy is doing better that it is. But stronger currency spells even more trouble for this exporting nation. When the unwinding process will be over, I would expect Rimnimbi to tank, but it will be too late.

Well, the Treasuries will be damped too, later on. China has about $500 bln of those and so far it’s only rising. This tide will reverse soon, I’m not ready to put a date, but I keep watching. When it all starts it will be very ugly here but even more ugly there.