China Has Contracted Humanity's Biggest 'Stomach Ulcer'

China Has Contracted Humanity's Biggest 'Stomach Ulcer'
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On the surface, it almost seemed as if Xi Jinping was channeling Donald Trump.  Opening China’s 19th Party Congress this week, the Communist General Secretary of that Congress talked a lot about “rejuvenation.” The word recalled the 2016 US Presidential campaign and the Republican’s promise to “make America great again.”  It seems as if finally the great halls of power around the world are finally being made to come to terms with 2008, even if they might not understand exactly why.

Secretary Xi described his vision in starkly difficult terms.  “Achieving national rejuvenation will be no walk in the park,” he told the 2,200 assembled Party delegates.  Perhaps recognizing the setting replete with more ritual and ceremony than effective policy debate, Xi further emphasized his command, dryly stating, “it will take more than drum beating and gong-clanging to get there.”

Where is there?

Ten years ago, “there” was never a question or a doubt. We know this because the government undertook the largest construction project in human history.  It has been said that China used more concrete in the last decade (plus a few years) than the US did in the entire 20th century.  The result of all that “investment” here down the road has been curious almost derision, the rise of so-called ghost cities.

But the idea of these ghost cities is a bit of a misnomer.  The thousands of empty buildings and apartment blocks are not what most people seem to think.  They were put up often at breakneck speed with the very purpose of standing idle until demand caught up. They were only ghost cities in the present tense, as each one was built on the expectation of temporary.

As I wrote back in July, “in truth China’s ghost cities aren’t about the past but its future.” Therefore, economic growth is paramount; it has always been paramount. 

When the urban conversion began in the form of these mega-projects, the Chinese government envisioned an original run of 20 new “cities” (that are often newly developed parts of existing cities or population centers) followed until 2026 by another 20 or 30 thereafter.  Some 300 to 500 million Chinese were expected to remove from rural subsistence farmer to urban factory worker. 

It’s the scale that is so often difficult to comprehend.  In places like Yujiapu in Tianjin, that ghost city recreated a new Manhattan, including a version of Rockefeller Center and even twin towers (no Statue of Liberty, though).  To our own national experience it seems like waste on an incomprehensible scale. But within the expected migration of 300 to 500 million former peasants who almost in the blink of an eye become middle class consumers, a brand new New York is but a question of time.

This demographic change, like all of them in human history, is not written in stone.  Economists like politicians like to extrapolate in straight lines because it’s the path of least resistance (and, frankly, the math doesn’t work otherwise). Complex systems, however, obey no such constraints.  In the context of statistical analysis, to intentionally undergo such a radical, national transformation required and still requires major assurances – meaning that anything that might interrupt the desired end must be nothing more than random, trivial chance.

Enter the Great “Recession.”

To statistical models, what happened starting in August 2007 was an impossibility.  That was the verdict of all the Western econometric models (which, for nth time, explains a lot), so though we aren’t privy to the Communist versions and their results, it is entirely reasonable to assume they felt the same way (again, they plunged forward into the ghost building business). 

The response to that “recession” was the typical, orthodox stuff. The People’s Bank of China pegged CNY to the dollar, meaning that it supplied “dollars” to Chinese banks still in need of them but unable to secure them on global eurodollar markets.  At the same time the government unleashed an accelerated construction schedule, speeding up infrastructure investment to become “stimulus.”  It is this part that often gets confused with the ghost cities as wasteful economic policy.

It happened again in 2011-12.  The global economy undertook a second shock which hit China particularly hard. It didn’t cause the same intensity of disruption or contraction as in 2009, but in many ways it has been far worse.  China’s economy, like the global economy, began at that time a gentler, persistent deceleration. 

Government response was again textbook, the operative theory being that China just needed another little boost to get back on track to pre-crisis growth. It was during this transition period that the 18th Party Congress took place in November 2012. Being introduced for the first time as his nation’s leader, Xi Jinping said, “we have every reason to be proud – proud but not complacent.”

His attention five years ago was on economic reform rather than rejuvenation, simply because five years ago every economist and central banker was convinced that given enough time the global economy would get back to 2005 again.  They could afford reform given the extrapolation back to unparalleled prosperity and growth.  For China, that simply meant a delay, or ghost cities that caught international attention for being without demand a little longer than originally planned. 

What really happened between then and now was hard reality.  Where Xi talks of “rejuvenation” today it really is nothing like the same-sounding idea expressed by his American counterpart.  Chinese renewal no longer really means that for the Chinese; it is instead the glossy cover for what is really a transition to a no-growth world.  When Xi uses that word, what he really means is that China must learn to be successful in facing this new paradigm.

The ghost cities are now expected to be completed, or nearly so, by 2020 rather than 2026 as believed a decade ago. Xi talked about the quality of China’s growth rather than emphasizing its speed. The building of the socialist paradise as envisioned long ago is suddenly now within reach, which has to make impartial observers not really versed in the economic statistics wonder what has changed.

The statistics themselves are actually quite grim.  Apart from a temporary bump at the end of last year, Chinese economic growth is still about the same as it was in the worst of the global “rising dollar” downturn.  That includes, importantly, Fixed Asset Investment (FAI). 

According to estimates published this week by China’s National Bureau of Statistics (NBS), GDP, industrial production, and retail sales all continued in the same low-level range that has existed since the start of 2015 (when the “rising dollar” first broke).  FAI, however, has dropped to a level unseen in decades.

The headline estimate for FAI is reported on an accumulated basis, meaning that what you see published for September is really for all nine months of this year up to and including September.  Accumulated FAI growth last month was just 7.5% (meaning FAI in the first nine months of 2017 were 7.5% more than in the first nine months of 2016).  The last time FAI was that low was at the end of 1999, a time when Asian flu was still a lingering concern rather than any idea of ghost cities.

It’s even worse, however, on the private side. About 40% of FAI is derived from State-owned enterprises, often the infrastructure investment and waste associated with the marriage between state and ghost city programs.  The rest is private FAI, or the necessary components leading the demographic changeover; the ghost cities themselves. 

The NBS did not report private FAI until March 2012.  When brand new General Secretary Xi Jinping addressed the opening of the 18th Party Congress that November, private FAI was growing at a 25% rate, down only a bit from almost 29% in that first published accumulated estimate.

The latest private FAI estimates suggest an accumulated growth rate of just 6%.  But even that number overstates the condition right now, influenced as it is by front-loaded activity associated with “reflation” dynamics left over from late last year. On a strictly monthly basis (meaning activity just in September 2017 compared to activity just in September 2016), private FAI grew by only 3.9%.  That follows 3.0% non-accumulated growth in August.

These are some of the lowest growth rates imaginable for China. Apart from a four month stretch in the middle of last year, they would be the worst. But that’s really the point in all this.  China’s lifeblood expansion is in later 2017 right back where it was in the middle of 2016 when even the mainstream was filled with (“unexpected”) talk of China’s so-called hard landing.  The rebound in yet another place from that “rising dollar” low point was transitory.

It’s not as if Chinese authorities have stood idly by, either.  To begin 2016, the federal government went back to the textbook approach, pushing an enormous amount of “stimulus” back through State-owned Enterprises in the form of that 40% public FAI.  The PBOC began a yearlong program of RMB expansion in the form of bank reserves (almost like a QE, with one important exception).  And it all came to nothing.

What other conclusion might Chinese officials make for their 19th Party Congress after the last five years?  They threw everything including the kitchen sink at the economy, and it hasn’t made one bit of difference.  Growth is gone. Twenty-first century Chinese rejuvenation is making the best of it, believing, or trying to make the Chinese people believe, in quality economy over quantity economy.

It’s a dangerous proposition, on several accounts.  Most of China’s debt was issued and refinanced under very different terms.  Don’t tell the bankers quality economy is the new order, or “new era” as Xi is claiming. Quality cannot service the massive amount of questionable lending. 

The ghost city approach has also spawned property price imbalances, in some places what are long past classic bubble terms.  But in China’s new era, “housing is for living rather than speculation” as the General Secretary just decreed. How do they get from the latter to the former without 20-30% export growth, 20% industrial production, and 30% FAI?

What’s more than both of those, of the 300 to 500 million peasants slated to become middle class workers, what happens if only 200 million end up having been given the order to move into the fancy new cities? (In truth, it doesn’t work like that; it works the same as anywhere else where the relatively affluent already in cities move into the new stuff and the newly arrived rural farmers take over the old left behind).  This is the real danger and the real task for the Chinese government.  A no-growth world means there isn’t anything for those still on the outside to do, and therefore no need for them in the cities.

It is, in short, a global economic problem, one which is putting China to its own early crossroads.  Before 2007, the Chinese were the world’s industrial engine, the nexus of Western demand meeting developing world resource extraction.  It all went into, and then came out of, the Chinese economy.  If the government who ten years before went “all in” on that economic model, what does it say about the global context for them now calling early success?

For one thing, it shows a tremendous amount of almost laudable (almost) realism. Unlike Western politicians and especially central bankers who continue on in reprehensible denial (Yellen, a perfect example of the DM central banker, still thinks inflation is coming, as she clung to “transitory” yet again just this past weekend), the Chinese have no such luxury.  It would be commendable if it wasn’t their own fault, having long ago made a deal with the devil – the eurodollar devil.

It was this global money system which made China, and for the last few years has threatened to unmake it.  That threat just became official doctrine.  China isn’t going to be an industrial powerhouse anymore because it can’t be; there are not enough “dollars” or really “dollar” capacity in the world any longer for that to continue to happen.

What was a seemingly cohesive global system when the eurodollar base was expanding has increasingly fragmented or devolved back toward individualism.  To fill that vacuum created by lost “dollar” capacity was first economic restraint (that is still ongoing, as should be completely obvious by now especially in economic accounts all across the world that in 2017 are falling back in the early 2016 direction) and now various proposed and actively ad hoc currency workarounds.

The Chinese themselves are actively trying as best they can to de-dollarize really out of necessity.  It just isn’t as simple as declaring that they would run the world on CNY and offering only those terms; the country is hugely dependent on trade, and global trade still runs on eurodollars (for however much longer). 

And so we are left in an unusual state, where the demand for “dollars” is likely shrinking (in non-linear if not absolute terms) as a result of small-scale de-dollarization plus global economic restraint.  But the supply of “dollars” is still shrinking, too, and it appears of late as if the pace of that reduction has picked up again.

I noted a few weeks ago the warning in US$ repo that matched up perfectly with the major inflection in both CNY as well as Hong Kong dollars.  In addition, cross currency basis swaps swung violently more negative again, too.  A negative swap premium is an unusually clear signal for imbalanced dollar demand in FX, or a negative variation in the still ongoing dollar shortage. 

So even if demand for “dollars” might not be robust or even falling, the supply of them might be doing the same at quicker pace (again). 

Whether that adds up to another “rising dollar” I don’t know, but it’s more and more a possibility. Beyond that, it is a symptom of the larger global problem, the one China cannot solve on its own though they have tried. The rest of the world doesn’t even acknowledge that the eurodollar system exists, let alone consider it may be the exceptional cause of so much global dysfunction and misery. The eurodollar system is unstable, and has been for ten years susceptible to these periodic disruptions. 

From the Chinese perspective, accepting this paradigm and putting the best possible face (this was the plan all along!!) on it makes sense; perhaps the best or least risky out of what are really only bad options.  What else can they do?  Until the eurodollar world comes to the table to talk about eurodollars there is no escape from the no-growth paradigm. And the eurodollar world doesn’t yet know that it is a eurodollar’s world. 

It’s this last part that most people have so much trouble with. Convention states that the dollar is the world’s reserve currency and that it is set by a bunch of fat old men at the Treasury Department. Therefore, if this is the way things are there must be good reasons for it.

The eurodollar is entirely different, both as a global system and now as its primary malady. It is, in fact, entirely human to overlook such obvious answers to common problems and symptoms. The medical field is filled with such examples.

It was once accepted “wisdom” that stomach ulcers were caused by stress, and even treated by medical doctors as if that was the case (sales of some really strong antacids and constant admonishments to reduce stress levels). A couple of more curious researchers in Australia had a different idea, one more basic and less nonspecific and convoluted; obvious, even. Human maladies, they knew, were most often caused by specific pathogens.

So Barry Marshall and Robin Warren set out to ask the question everyone already “knew” the answer to.  And they succeeded in proving what couldn’t be wrong really was (Helicobacter pylori bacteria). Marshall described it to Slate in 2010:

“So we said, ‘Hang on a minute, scientists have been trying to find the cause of ulcers for 50 years. Have they checked out the possibility that it could be an infection?’ The answer was, ‘No, because it's impossible for bacteria to live in the stomach. We wouldn't even consider that.’”

It’s impossible the world has a money problem; economists won’t even consider that. China has contracted humanity’s biggest stomach ulcer, and they are stuck with a roll of Tums (at least it’s extra strength mint) to try and treat it.  And now its government just announced a systemic program to reduce stress.  No wonder the global bond market prognosis remains so highly negative despite so much monetary doctor optimism.  

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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