A Chinese financial and economic crisis is inevitable. So far, China has managed to skirt a catastrophe by the skin of its teeth. But China is a paper tiger that is starting to experience a wicked kind of economic entropy and broad-based, multi-sector contraction. VIVISXN’s economic team believes a crisis there is inescapable given the PRC’s zonked out growth model, global macro/geopolitical fretfulness and a dizzying debt load. Many of the world’s most eggheaded economists agree. A countdown to the meltdown has begun.
China has essentially hit a great brick wall — what development economists call the ‘middle income trap.’ This happens to developing economies when they have picked off all the low hanging cherries and exhausted all their cheapo factor endowments, as China has ravenously done for the past few decades. A new inflection point is well-nigh.
The transition to high-income status necessitates far more than repetitive, low-value assembly-style jobs staffed by country folk and clodhoppers moving to the cities. It requires the creation and adoption of high-value-added products and processes enabled by bleeding-edge technology, strategic thinking and a culture of true and tenacious innovation.
China has not shown much capacity for developing high tech breakthroughs on its own, but it has been astonishingly effective at stealing oodles of technology and IP from various trading partners (mostly America) and applying it through its own system of state-owned enterprises and ‘national champions’ such as hyper-hacker Huawei in the telcos sector, Ant Financial in fintech, DiDi in ridesharing and Fourth Paradigm in AI — all enterprises that appropriated (um, ripped-off) non-Chinese, predominantly Western intellectual property.
Unfortunately for China, this ‘growth by theft’ model has run its course. The U.S. and its allies, such as Canada, Japan and the EU, are taking strict measures to limit further theft and are holding China fully accountable for its kleptomaniacal tactics — so far by imposing punitive tariffs and banning Chinese firms from participating in critical, next gen tech rollouts such as 5G networking and advanced semiconductor purchases. Huawei thinks it can hoodwink the world. It can’t. Pandas can’t fly. Duh.
At the same time, China is facing the painful consequences of crushing debt. Economies can grow through various modes of consumption, investment, government spending and net exports. The ‘Chinese miracle’ has been mostly a matter of fixed asset investment and net exports, with minimal spending by consumers. It is hyped to the max and leveraged to the hilt.
The investment component masqueraded as government spending for decades — many of the companies pouring investment into large infrastructure projects were backed directly or indirectly by the government through state-backed banks, steroidal SPVs and commie VCs.
This investment was debt-financed, of course. China is so heavily indebted that current incremental spending now produces zero (or negative) returns and generates zilch growth. Adding additional debt today via the PBOC’s ‘credit impulse’ slows the economy and calls into question China’s ability to service its existing debt. Margin rates are rising in China, collateral requirements are fussier and rehypothecation is sketchier than ever. Default rates — both private sector firms and SOEs — are proliferating. Confucius and Buddha, knowing full well the immutable laws of economics, are spinning in circles somewhere in the God realm.It’s an ugly story, and it’s all very obvious, like Lo Mein noodles hurled against the wall. China’s other lifelines were net exports and large current account surpluses. These were driven by cheap labor, government subsidies and a systematically manipulated currency. These drivers of growth are disappearing due to demographics that dilute China’s (shrinking) labor force, capital outflows and waning capital expenditures. Other noodle wads plastered on the wall range from China’s ill-conceived Belt and Road Forum (BARF), the surveillance state’s panopticon scheme against its own people (good luck ‘disrupting’ industries à la techno-punk Steve Jobs), and the hubristic and feckless attempt at hegemony in the Indo-Pac region (it would only take a few Japanese attack subs alone to KO China’s nascent blue water navy). The commies could never stomach such humiliation.
China is facing competition from Vietnam, Indonesia, Cambodia, etc. — regional players that offer a superior labor arbitrage, a better FDI climate and higher returns on assets. Current account surpluses are also being eroded by President Trump’s tariff policy and penalties imposed by the U.S. Treasury. Data around China’s FX stash is perennially fudged and official stats are as accurate as Jussie Smollett’s Chi-Town (faux) ambush story. Foreign invested enterprises will tell you firsthand that ‘the law of diminishing returns’ applies to China like never before.
Meanwhile, the debt overhang is growing exponentially worse. China’s creditworthiness is now being called into question by international banks, foreign investors and rating agencies.
The single most important issue is the continuation and escalation of the U.S.-China trade spat. When the trade war began in January 2018, the market expectation was that both sides were merely posturing and that a resolution would be quickly negotiated. Please.
VIVISXN took the opposite view. Trump sat in office a full year before he started confronting China’s neo-mercantilist shenanigans. He has given China every opportunity to come to the table and work out a diplomatic deal commensurate with both nations’ interests. China has miscalculated at every turn.
China assumed it was ‘business as usual’ — a breezy continuation of the Clinton, Bush and Obama administrations. The leadership reckoned it could pay lip service to trade relations and offer occasional concessions, and continue with its predatory economics and nervy theft of intellectual property.
By January 2018 the patience wore thin and the Trump team resolved to take on China’s trade transgressions and digital piracy. Since the trade squabble began, the U.S. has suffered only minor impacts, while the net impact on China has been overwhelmingly adverse and injurious to its growth path and political climate.
The deteriorating situation in China is eloquently conveyed in this excerpt from an article titled ‘The Coming China Shock,’ by economists Arvind Subramanian and Josh Felman:
“Back in September, we saw some discontinuity in China’s economic performance as inevitable. Even if the country was not heading for a full-blown crisis, we believed it would almost certainly experience some combination of rapidly decelerating growth and a sharply depreciating exchange rate. That prognosis has since become even more likely. With global economic growth and exports declining, China’s economy is on track to slow further relative to the 6.4% growth recorded in the fourth quarter of 2018. The double-digit average achieved from the 1980s until recently has never seemed more distant.”
The impact described by Subramanian and Felman is illustrated in the graphs below. These charts show the price, implied vol spread and volume of trading in the iShares China Large-Cap ETF (NYSE:FXI), an imperfect proxy for China investors but nevertheless informative:
FXI peaked at $54.00 per share on Jan. 26, 2018, around the same time the trade war commenced. The index has trended steadily downward from there to the current level of about $40-44 range, a -21% decline with swooning volatility along the way. If you used a leveraged inverse instrument and options, as we have done (or structured notes), you made windfall profits betting against China’s steady decline. Active managers specializing in ‘event driven‘ strategies can buy the dips and dynamically hedge – another ‘alpha-generating’ way to exploit China’s gyrations (peep the vol spread below – a short-term buy signal for those gutsy enough).
This decline is only a partial reflection of the trade war dynamics. Wall Street has consistently underestimated the hardcore economic toll the squabble has had on China. Traders and investors formed the view that the wrangle would be short-lived with inconsequential results. Instead it has stretched for 14 months with no end in sight. Trump & Co. are about to tweak the row asymmetrically in favor of America — a good thing for enlightened societies that cherish freedom, democracy and the rule of law.
The tariffs imposed by the U.S. on China so far have dramatically slowed down the Chinese economy. Yet those tariffs are peanuts compared to what’s coming.
March 1, 2019 is the deadline for a “truce” in the trade war, intended to facilitate negotiations and foster mutually agreed upon rules and codes of conduct. America’s demands — especially verifiable limitations on the theft of U.S. intellectual property — are impossible for China to meet because it depends on incessant theft to advance its own economic, political and social ambitions.
It is highly unlikely that the critical issue areas of piracy, espionage and cyber security will be resolved by March 1. Some minor issues may be resolved and a superficial “deal” announced. Such a deal may include a reduction in the U.S.-China trade deficit through larger purchases of U.S. soybeans and other ag products by China, and perhaps a stabler FX regime. But the big issues including limits on U.S. investment in China, forced technology transfers and IP bootlegging will not be resolved.
The best case is that President Trump’s deadline will be extended and negotiations will continue (blah). The worst case is that a ‘trade truce’ will crumble and the U.S. will impose massive punitive tariffs on China while subverting Beijing’s nefarious industrial policy (‘Made in China 2025‘) and geostrategic ambitions (‘One Belt, One Road‘). Either way, China’s export-driven economy will continue to suffer and the Middle Kingdom will continue its downward spiral.
Given these macroeconomic, financial and geopolitical headwinds, weakness in China will only get worse. Xi Jinping, China’s self-appointed ‘emperor for life’ is blundering bigly. Entropy is having its wicked way with China’s economic destiny, first by transmogrifying the society into an intensified klepto-Orwellian racket, and then by dissipating it as angst all over the country and beyond. There will be blood.
And China’s governing elite can only hope the damage can be contained before the serfs begin to question the legitimacy of the ruling class. We predict a wave of chaos coming to China that will be uncomfortably sharp and disorienting — especially for ordinary citizens and global investors alike. We are staying short of Chinese equities, ADRs, the RMB/$¥ and select bonds.
China has visibly entered the ‘phase transition zone’, a process of critical transformation that will eventually lead to a new equilibrium at significantly different levels, after severe ruptures and a possible full-cycle crash. China will not know what hit it as it emergently self-reorganizes back into something that resembles the old-school feudalism of yore. America, the IMF and myriad hedge funds will be there to offer it a credit facility and invest when the smoke clears. Expect fireworks and fuming theatrics shortly.
Images Chen Man + Ren Hang + Wikimedia Commons
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