The Path to Growth Isn't In Any Economics Textbook

The Path to Growth Isn't In Any Economics Textbook
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He said that his company’s rival had been trying to orchestrate its downfall, and finally it had succeeded. Complaining about it publicly, though, and with the government involved trying to find a non-disruptive solution, Zhao Qiang soon found himself detained by the police. As Executive Vice President of Qixing Group, an aluminum smelter in China’s Shandong province, news of Zhao’s and Qixing’s trouble in early 2017 didn’t cause much widespread attention.

This was unlike what had happened several years before. Late in 2013, for the first time in its modern economic history there were rumors China’s government was going to allow defaults in the country’s rapidly growing corporate bond market.  Like GSE’s in the US, there had always been assumed some sort of implicit backstop, though rarely ever put to any serious test.

The Chinese economy had grown rapidly for decades. As a global center for industry and manufacturing, businesses in those sectors were seemingly impervious to the ups and downs that affected overseas counterparts.

Aluminum and steel, two of the biggest bright spots in the Chinese landscape, suddenly around 2012 and 2013 their shine began to dim. Whispers of the dreaded word “overcapacity” became almost commonplace. Stunned by the turn of events, investors (globally) began to ask questions about China that they never thought would be applicable there.

Can Chinese corporates really default? What happened to the growth which was supposed to have prevented them?

There would be, in fact, bankruptcies, credit restructuring, and more painful debt adjustments. Especially in steel and aluminum. For reasons you aren’t supposed to talk about, Western economies just aren’t buying as much as they used to from China. Or anywhere.

Coming to grips with this altered state long before anyone in the West has, China’s Communist leaders decided that the nation would change. It would have to change…or else. If its vast industrial sector couldn’t count on external demand for its produce, then the Chinese people themselves would fill in that demand gap (again, or else).

Rebalancing, they called it.

Terrific branding. Nothing more than a cover story. And, as usual, Economists and policymakers outside of China couldn’t laud the Communists enough for their insightful brilliance. The daring technocrats had outsmarted everyone yet again.

Except, the only reason the very idea of rebalancing was ever thought up was because everything else was failing. It wasn’t a proactive way to launch China into a leading 21st century position; it was instead the last gasp at holding on before the ugly prospects of decay were forced piecemeal across the whole economic and then political landscape.

China’s last ditch.

For one thing, the Chinese had done everything the Western Economics textbook, the one written in the language of Keynes, had told them to do. In response to the “somehow” Global Financial Crisis and the “somehow” global Great “Recession” that came along with it, China’s government went absolutely nuts. Complete insanity.

Over here, they called it aggressive stimulus. The Communists would remove prior restraints on everything from credit to spending caps, no more fiscal knuckle-wrapping over missing budgetary limits. Flowing through the local governments first and their state-owned businesses and others with close ties to them, those like Qixang, ostensibly aluminum smelters soon found themselves as real estate developers and asset managers.

If you were politically connected, it was all-too-easy to find financing for any pie-in-the-sky scheme. Didn’t matter. China’s once frugal and, from the Communist perspective, evolved scientific approach had been cast aside by utter necessity. The need to grow was seen as the first requirement to survival.

In 2009, 2010, and 2011, that meant simply to buy time. Let the system explore and even explode its past limits and then when organic growth resumed that would be the time to clean it all up. Real economic growth does wonders for even the messiest situations (see: 1950’s).

By 2012, however, authorities were horrified to find that instead of global recovery there was instead a worldwide slowdown. Worse, over the next several years it proved intractable. Europe fell into another deep recession while the United States, China’s number one customer, nearly did. In both cases, the writing was on the wall about the baseline state of the world economy. It wasn’t coming back.

That past aggression over stimulus suddenly looks very different. No longer buying time, Chinese officials realized it would be an enormous danger. Without growth coming from somewhere, China was at risk of becoming just another typical basket case study.

The IMF late in 2016 said exactly that. What the Chinese were experiencing up to 2014 and 2015 was the same as the organization had seen in Spain from 1998 to 2008, Thailand 1986 to 1996, and, yes, Japan 1980 to 1989. You might recognize the common characteristic among those on that list for how none of those cases ended well. What followed each time was, as the IMF report put it, “painful deleveraging.”

The response from China was denial, of course, as well as quiet recognition of what “painful deleveraging” would mean there in a way it hadn’t for those others. As is commonly believed, any country which can print its own currency can maintain and even moderate its debt – overhang or not. The Chinese did not have an external debt situation, they said. One thing everyone can be sure of, it is that the Chinese government is well aware of, and more than a little frightened of, the similarities its economy today shares with Japan’s economy of the eighties.

What many believe had been Japan’s biggest vulnerability wasn’t just that its corporate sector had binged on debt, it was more so how that sector was able to borrow so much. A company’s debts rarely obligated just the one company. It was common practice for corporate “families” to share them, or, at the very least, for one member of a group to guarantee the debt of others.

When the credit crisis hit, losses and the potential for problems became widespread well beyond the specific cases of insolvency and bankruptcy. Just as there is contagion in the banking world, the possibility also exists for corporates. Ask Japan Inc. circa 1990.

As it turns out, Qixing’s debt problem in 2017 came at an opportune moment – for the rest of China and its corporate bond market if not so much for Zhao Qiang and his inopportune time in police custody. The reason that first wave of bond market rumbling in 2013 and 2014 created so much havoc in 2015 was because of the (global) economic downturn which struck at that time.

A single default maybe two are looked at in good times as idiosyncratic events and little more. In bad times, they are, again, the possible seeds of contagion. Risks, systemic risks, are always elevated when growth is questionable.

For Qixing in 2017, there was this widely accepted trend toward globally synchronized growth. China, many would come to believe, had experienced its “growth scare” during that former period between 2013 and 2017. Having put things right, by rediscovering the Keynes textbook in early 2016, all of that nastiness about debt and wasted stimulus could be put behind. Rapid growth would mean breathing room for restructuring even there really wasn’t any rebalancing.

Not just in China, this was supposed to mean only good things for the whole global economy supported mainly by the Chinese resurrection.

As I wrote a few weeks ago, though, not everyone in the Communist government had been convinced this was the case. Li Keqiang, a trained Western Economist and the country’s nominal number two, was the leading proponent behind 2016’s stimulus panic. He appears to have been opposed by China’s President seeking to consolidate his power, strongman Xi Jinping.

By late 2017 and early 2018, before “trade wars” really began, Xi’s government had already been cracking down on overcapacity particularly in steel and aluminum. The New York Times wrote last March of what was really an agreement on both sides of the issue, China and America:

“President Trump imposed steep new tariffs on steel and aluminum imports last week, amid complaints from American companies that the Chinese government props up too many wasteful factories… and many Chinese officials agree. In that way, Mr. Trump’s tariffs are aimed at trade battles of the past.

“Even as China makes veiled threats to retaliate against the United States, it is forcing many Chinese companies to close wasteful, polluting factories to fix its economy and clean up its skies.”

But it was not about being conciliatory on an international stage. Globally synchronized growth was a total failure. If closing smelters and steel-ers gained Xi some good faith with Trump, I’m sure he took it and didn’t think twice. The entire issue, though, remains overcapacity, lack of economic growth, and how deathly afraid the Chinese regime is of following in Japan’s footsteps knowing they really can’t print their way out of it.

The good news is that they’ve already somewhat stepped off Japan’s path; once the debt binge reached its zenith in 1989, starting in 1990 Japan was straight away plunged into its Dark Age. The great crash from which Japan Inc. has never recovered even now thirty years later.

The Chinese, by contrast, have avoided at least the immediate plunge. If 2013 China was as 1989 Japan in terms of the height of its corporate sector dangers, 2014 was no 1990 in terms of economy and markets.

But that’s the end of the good news, as Xi Jinping is no doubt aware. There remains the frightening possibility that China is still heading toward Japan if only at a lesser pace. Five years forward, and we still haven’t seen China’s economy hit bottom. The ultimate destination might yet be the same, a system without legitimate growth, what’s different may only be how each might have arrived.

One key reason why: the rival company Zhao Qiang went to jail over. When Qixing began defaulting on its various obligations several years ago, the local government in Zouping had to act quickly to prevent not just worker unrest (those who hadn’t been paid) but also corporate unrest. Those defaulted debts were also guaranteed by other firms all across the heavy industrial city and region.

Factories and other physical assets had been given as collateral to competing producers, those like industrial conglomerate Xiwang Group which had in exchange issued debt guarantees for Qixang. Had the government not intervened, it is likely that many of the facilities in question would’ve been shut down while the parties fought over the paper trail.

Uncertainty over unrest in Xi’s no-growth China more and more leads to police visits and crackdowns. Thus, Zhao’s ugly predicament.

Xiwang had guaranteed a reported $421 million of Qixang paper backed by specific physical assets as collateral. That gave the company an edge in order to emerge as the victor. A spokesman for Qixang, Li Zemin, was quoted in the New York Times as lamenting, “Xiwang has always wanted to merge with us, but the appearance of their devouring us is bad.” No word on whether Li was arrested, too.

In more recent months, corporate leaders at Xiwang may be having second thoughts about that devouring. While they successfully acquired Qixang over its forgotten defaults during 2017’s vapid but accepted globally synchronized growth, it is now Xiwang’s turn to slip on the noose. The economic recovery was fake but the credit problems were not; therefore, the debts continue to pile up no matter how they are transferred or transformed.

And in 2019, the only thing synchronized is another global downturn (the fourth).

In late 2015, perceived as one of China’s more healthy and stable industrial firms, even though steel was still its backbone, Xiwang had floated a RMB 1 billion note with a put option set to expire last week. Given the way things are going in China, the company expected that option to be exercised and tried to raise funds in debt markets ahead of time. It hasn’t been able.

The put option on the one 2015 note is just the first of several, totaling perhaps as much as RMB 8 billion over the next year. The company already tapped a local government rescue fund for companies struggling with liquidity issues to the tune of RMB 3 billion already.

The 2015 note is now in default and is only trading at 50 rather than zero because speculators are betting Zouping’s if not Shandong’s government will be forced to step in and bail Xiwang out. If they are allowed to by officials in Beijing.

Another idiosyncrasy for the market to digest? Hardly. Not only had Xiwang guaranteed debts from Qiwang, it has guaranteed debts of other companies in the same region struggling in the same way it is. Among them, the sole state-owned power supplier for Zouping.

China doesn’t have an external debt problem, the government said in response to the IMF in 2016. Technically true but functionally irrelevant. They have an enormous external money problem.

Corporate defaults raise the risk profile especially in light of so many often hidden cross-guarantees. Mistrust gets embedded, often literally in econometric and quant models. Japan-style contagion. As the perception of risk rises, the dollars disappear and so, too, does the economy caught in between growing paralysis in business and the PBOC’s balance sheet reality which must constrict RMB growth as a response to fewer dollars flowing in.

Which only makes it harder for struggling corporates to raise funds, increasing default risks, raising the risk profile, disappearing dollars, etc.  Rinse. Repeat.

Li Keqiang believed, like all good standing Keynesians, that he could break the cycle in 2016 with a good double dose of stimulus. He couldn’t. It was just as Xi Jinping (and Uncle He) had predicted at around the same time.

China’s National Bureau of Statistics reported yesterday its Purchasing Managers Index (PMI) for services and non-manufacturing fell to 52.8 in the month of October 2019. That’s the second lowest on record. Only February 2016, China’s worst month during that 2014 to 2016 stretch, had been lower (and by just 0.1). Li will not be riding to the rescue this time. Appearing to, anyway.

Rebalancing? No, like globally synchronized growth it was never anything more than a bumper sticker slogan to try and reassure global investors in order to keep their dollars flowing to, and available for, China. For the record, the industrial and manufacturing side fared no better this month, the NBS Manufacturing PMI dropping to 49.3 (among the lowest on record).

These forward-looking estimates follow economic figures like retail sales and industrial production that in recent months have been at record lows. And those are the official numbers.

The eurodollar system reigns supreme in current practice. For a long time, that was thought to be a very good thing even though hardly anyone know what was really going on out there in the offshore shadows. And what that had meant for a great deal of onshore behavior.

Theoretically, the Communist government can do whatever it wants – including using its actual printing press. But to do so, that would require breaking every single monetary and financial convention currently in use. If you think China looks risky today, what do the risks look like with Beijing completely unhinged and unleashed? Putting the fiat in fiat. Very likely it’s worse than how things are now and very likely Xi’s side knows it.

That’s why Li Keqiang’s entire portfolio of economic affairs has been transferred to Liu He.

China’s dollar problem is therefore the world economy’s biggest drag on growth (just ask the Europeans, especially the Germans) as well as its biggest danger to stability (just ask another local electorate in Germany). Not just its recent eurodollar stumble, but far more than a decade of what’s been built up under false pretenses. The sky was always the limit, even in 2011 and 2012.

Until it wasn’t. And when, in a brief moment of clarity away from this so-called boom, you hear American officials tell it, damn Baby Boomers retiring and leaving the work force to drug addicted Americans who won’t go back to school anyway (R*). What else could it be that could wreak so much havoc worldwide and leave every corner of the globe to fend off only such inflexibly negative trends?

Even five years later, there’s still way too much Japan of China. Perhaps more now than we ever thought then. Stimulus hasn’t bought time; it has consistently squandered it. There is legitimate growth to be had in this world, a way out before Xi Jinping and those like him feel enough justified to take things too far as Zhao Qiang might tell you – if he could. That path just is not in the current Economics textbook.

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

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