On July 16, 2014, Premier of China Li Keqiang freed up more money for railway spending and reduced reserve requirements to spend more money on housing. The International Monetary Fund realizes that 10% growth is not realistic. In fact, Chinese real estate is undergoing a reversal of its state. The one child policy has put an enormous amount of stress on the rural regions of the country. In the rural regions, the population is much older and the urbanization policy that China has will not work for them. All the development in the last few years has created a large surplus in real estate that even the rural workers are unable to afford. It's like carting millions of mules to occupy urban space, an unusual and unpractical strategy in the modern world in terms of building economic growth. Beijing has never represented rural China. The level of distrust in rural China has risen exponentially because of the drug trade. Chinese drug lords are sanctioned by local authorities and local governments. In China, anyone caught with drugs is sentenced to execution by the state. This leads to the execution of thousands of rural female drug traffickers as drug lords expose them to authorities. This easily steals the spotlight from bigger shipments that go unnoticed and distributed. The local rural regions have a hierarchy in regards to the expendability of their population. In the rural regions, local authorities have built bridges that no one uses and infrastructure that no one can support. The unprecedented amount of real estate will burden the rural regions and their savings in order to support real estate that was built without prior thought.
With China's slowdown, they are more inclined to incorporate mini stimulus packages to prevent their economy from growing less than 7.5%. It is a threshold that many investors feel comfortable where the global markets can continue to climb and support higher commodity prices. The dilemma for China is to stabilize growth even though many of the infrastructure projects are laden with debt. Businesses are grappling with overcapacity by rolling over new loans and not paying off existing loans. For China to cut interest rates in order for state-run banks to lend more for frivolous expansion projects that have little or no use to benefit the people of China is a problem as banks may find it insufficient to carry out more loans that may be delinquent in the future. Unlike the real estate sector, analysts agree the railway system isn't facing an overcapacity. China Railway Construction Corp. Ltd. ADR (OTCPK:CWYCY) has a $10 billion market cap, a dividend yield of 2.21%, and grows at an annual rate of 10%. It is one of the few stable growth stocks that China possesses with minimal volatility. However, as the property market continues to slow down, added stimulus is needed to support their growth initiatives that put them at odds with the International Monetary Fund's own initiatives.
It is interesting how the International Monetary Fund seems to act even when their research teams have raised red flags over a year ago. Bear in mind, it wasn't until Jorg Decressin, the Senior Advisor in the International Monetary Fund's Research Department, stated in April of 2013 that "I'm not concerned in any major way about a hard landing for China." This is when he clearly knew that there was a lot of credit expansion in China outside the banking system. He evidently knew that China's shadow banking is worth an estimated 3.7 trillion, close to 44% of GDP and 25% of total outstanding credit. The effects will easily have disastrous consequences on the Dow Jones, SPY, NASDAQ, QQQ, FXI, EEM, VTI, IWM, VXX, HEDJ, etc. It really plays out like the iconic movie Scarface in the scene where the cartel members were sitting on the couch, watching themselves being exposed by their own hypocrisy as part of being a legitimate society. Now in 2014, the International Monetary Fund is scolding China to refrain from any more stimuli to boost economic growth and to curb shadow banking and local government debt immediately. In 2014, First Deputy Managing Director of the International Monetary Fund David Lipton, stated, "We consider that vulnerabilities have risen to the point where containing them should be a priority and therefore further stimulus should only be deployed if growth is 'significantly' below this year's growth targets. What the International Monetary Fund wants from China is to stop spending money on insignificant projects."
China has now embraced materialistic culture and capitalism, including high-end luxury consumption. The International Monetary Fund somehow believes that Chinese consumers aren't motivated by a desire to impress others with the ability to pay extraordinary prices for prestige products. The Chinese social status is not measured by wealth or social ranking unlike America. The International Monetary Fund believes that the rising expectations of the Chinese people to have more growth should now be limited because they say otherwise. The risky unregulated financial system that China has is not acceptable to the belief system of the International Monetary Fund anymore. Where the hell was the International Monetary Fund two years ago? The International Monetary fund clearly knew that Chinese households pooled their money into underground Chinese lending syndicates for commercial businesses and real estate. Where was the leadership? With the full blessing of the International Monetary Fund, Russia and China can now establish their own credit rating agency. This has more to do with China's worries that any bad feedback from credit agencies in North America could possibly derail or expose their economy.
On July 14, 2014, the International Monetary Fund Executive Board concluded that there's a real risk in the slowdown of emerging markets, especially China. This poses a risk to the recovery of the Euro because of the limited policy space in the near term. Negative shock in either domestic or external factors may arise which could halter their economy and push it into lower inflation and even deflation. The slowdown of the Chinese economy poses downside risk for the Euro's recovery. However, the recovery is neither robust nor sufficiently strong. Weak aggregate demand is weighing on real activity and pulling down inflation across the euro area, as corporates, households and banks continue to repair their balance sheets. Financial markets are still fragmented, with contracting credit and high borrowing costs constraining investment in countries with large output gaps, large debt burdens, and high unemployment. The economic researchers of the International Monetary Fund are the best in the world. They're able to enlighten us with problems that will arise in the future. However, there is a lack of leadership in the executive branch that are wined and dined by Asian government officials.
Changyong Rhee, Director of the Asia and Pacific Department of the International Monetary Fund indicated, "One good news is that when our Managing Director Christine Lagarde and I visited China last month, we met many senior Chinese officials and they all understand this problem very well. They are now doing many steps, many structural reforms to address this leverage issue and also shadow banking issues. It won't be an easy. They all say that it will be a bumpy course. But I think that given the authorities understand this problem and are addressing this problem, we hope that it can be solved gradually. Thank you." Unfortunately, for economists, the word 'thank you' is not enough. What are China's structural reforms that they are going to address and what steps are they taking? What long-term format are they using to address the irregularities of shadow banking? If China understands the problem, then why wasn't it resolved years ago? Changyong Rhee also indicated, "But on the other hand, if the credit expands more and more, then I think Chinese government will find later on it will be very difficult to handle it, especially if it's combined with a real estate slowdown. That can cause some problems not easy to solve." So now we know that China's credit growth leverage that is continuing will cause large problems in the future. We also know now that China's leverage has increased significantly since the 2008 Global Financial Crisis as part of their stimulus package to cope with the slowdown of the Chinese economy.
Now, most of China's debt is channeled through so-called 'shadow banking'. The Chinese government heavily relied on real estate investment as a way to boost demand. However, it became an oversupply. As opposed to prices being diminished in the real estate sector due to the oversupply, the real estate prices increased in order to get more loans. If China believes the social rank of a rural worker is to ascend quickly and for them to use their life savings to purchase real estates in order to mask out the delinquent loans perpetuated by shadow banking, then perhaps China understands the problem better than the International Monetary Fund. For the Chinese, the problem is that there isn't a problem. It's only the International Monetary Fund's concerns that seem to bother them. Changyong Rhee may be wrong that Asia will continue to grow but should not be complacent due to the risks. Rhee implied that Japan, Singapore, and Hong Kong should continue to maintain their accommodative policy stance. However, China should pull-back their credit expansion. It's like saying China should not be as competitive as their neighbors. When you lose business to your neighbors, it may be hard getting it back.
China's healthcare infrastructure has a lot to be desired. The government goal by 2015 is to have 20% of all hospital beds across the country run through private investment. First of all, doctors are underpaid. Their monthly salaries are as low as $300. Doctors are getting kickbacks from drug companies to administer antibiotics. In fact, their whole healthcare system is based on antibiotics. Doctors use tests and procedures as a supplement to their income. If your family has money, not only are you able to see a doctor quicker, but you're also able to administer antibiotics quicker. It is a fully capitalistic healthcare system. On July 29, 2013, The UK Pharmaceutical giant, GlaxoSmithKline, was caught by officials for passing bribes totaling $480 million to hospitals and doctors. It wasn't so much the bribe itself, it was because the money wasn't funneled through the right government officials which led to their exposure. Hoarding money often creates an idiosyncratic jealousy, especially from party members that receive no cash.
The International Monetary Fund wants China to resolve its problems by achieving slower and stable growth, placing them at odds with many analysts' rising expectations of faster growth. The International Monetary Fund is looking to China to liberalize their rates, introduce deposit insurance, and most of all, re-introduce a stable real estate market without leveraging more loans. There are three simple words the International Monetary Fund understands most about an aging population and China understands it even more: no more time, or else the real estate market will implode, therefore impeding global recovery.
Special thanks to Fiorenzo Arcadi for contributing to this article.
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