Possible Black Swan Events Developing In China

Includes: FXI, GLD, GXC, SLV
by: Robert Wagner

Watching the news yesterday about the Chinese banking crisis a few things stood out as being very odd. The first observation was that gold sold off, and the second observation was that the US 10 year treasury yield actually increased. Normally when there is panic selling the safe haven instruments do well, especially when the news involves a banking crisis.

This video gives some clues as to why the safe haven investments may not benefit from a crisis in China. First, a banking crisis in China would almost certainly depress China's demand for gold. Not only would the crisis likely result in falling demand, but if the banking crisis grows, the Chinese Central Bank may need to sell its gold reserves in order to satisfy its liquidity needs. Fear of Chinese Central Bank selling of gold may have been one of the reasons gold performed so poorly today in the face of such bad news.

The same reasoning may explain why the 10 year Treasuries didn't rally as well. China is the largest foreign holder of US Treasuries. If China is forced into selling their US Treasuries, US interest rates should increase. Fear of Chinese Central Bank selling may have been one of the reasons Treasuries performed so poorly today in the face of such bad news.

The other issue from the video that caught my attention was how nonchalant the Chinese Central Bank was about the crisis, as if the Lehman Brothers event never happened. One would have expected that post-Lehman Brothers central banks would be overly sensitive towards the risk of a catastrophic banking collapse, but at least from this video, that impression isn't given.

Another video points out that interbank lending froze up overnight, and yet the Chinese Central Bank did nothing. The other comment was that the Chinese Central Bank may be intentionally doing that in order to crush the "shadow banking" system. We didn't have bank runs in the US because we don't have a shadow banking system. It will be interesting to see how a shadow banking system performs if bank runs develop. My bet is it won't be pretty, and result in a Chinese banking system collapse much worse than the market is anticipating, much like what happened in 2008.

China is possibly headed into its first major banking crisis of its modern era. Unlike the US Federal Reserve, the Chinese Central Bank is a highly politicized component of their centralized command and control economy. The central planners have already done a poor job allocating their bank reserves, and it stands to be seen if they can do a better job managing a crisis than they have the expansion. Once again, my bet is it won't be pretty, especially if part of their plan is to eliminate the shadow banking system.

The articles I love to write for Seeking Alpha are the "see I told you so articles" where I write an article and then shortly afterwards the theory outlined is proven. I did that for the Bitcoin, Gold, various stocks and now China joins the list. In the linked article "How To Invest If China is A Bubble" I kind of hedged by using the word "if" China is a bursting bubble because bubbles, especially central government backed bubble, always seem to last longer than I would expect. I recently lost a bet on gold because gold remained in the stratosphere longer than I had expected. The price target was eventually reached proving my point, but I still lost the bet. This quote from the article captures its spirit.

For another perspective, Dennis Gartman is saying buy Chinese stocks. This article however addresses what to invest in and what to avoid if China is a bubble, and an investor wants to capitalize on a potential collapse of the Chinese market.

The article however provided a good review of what to own if the Chinese market was a bubble ready to burst. Since the writing of the article China is looking more and more like an economy in trouble, and if their markets aren't a bursting bubble, they are at least in a serious correction...and this is just the start of a potential banking crisis.

This video released yesterday reviews the Chinese banking crisis and Chinese market correction. The term "Ponzi Scheme" is used frequently and is in the title, and that is rarely a positive sign for anything. Key points made in the video are:

1) The Chinese economy and banking system is an inefficient centralized government run economy and banking system. Those systems are almost always "unsustainable."

2) The Chinese government has plenty of money to perpetuate the "Ponzi Scheme."

3) The Chinese government has described their system as a "Ponzi Scheme."

4) "Just like any bubble it can go on longer than you think."

This video highlights two key point:

1) We are potentially at a "watershed moment" for China's new economy.

2) It could get "really scary" if the Chinese make a mistake in execution.

Another point highlighted in the video is that the Chinese Central Bank is going to "pick and choose winners and losers" and is "willing to tolerate a slower growing China" to clean up part of the financial system.

Calling a top to the Chinese bubble, if in fact it is a bubble, will be more difficult to call and can go on longer than other bubbles because this possible bubble has a totalitarian centralized government backing it. The Chinese government has tremendous reserves to continue to prop up their "Ponzi Scheme." Why this is important is that if the Chinese government can prop up their "Ponzi Scheme" long enough for their non-productive non-producing assets to become productive, it might actually work. If the Chinese government can keep the system running long enough to populate the vacant ghost cities, staff the empty and idle factories and efficiently allocate resources to keep everything running in a hyper-dynamic global market it just might work. The problem is no totalitarian communist authoritarian command and control government has ever succeed at doing that in history, and that is a good thing for freedom loving people worldwide. The two things however that are most likely to pop the Chinese economic bubble would be an uncontrolled banking crisis or an international relations crisis, both of which are brewing. The foundation for both those Black Swan events are making headlines today, and investors should take note.

While the financial media has been focused on the emerging banking crisis in China, another less reported story may be as important or even more important to the Chinese financial markets. The entire Chinese economy is based upon foreign investment and exports. If anything was to ever disrupt that model, it would be devastating for the Chinese economy. For that to happen it would require a major international incident, and that is exactly what may be happening right now in China.

In order for the free market to work, the rule of law must be respected. In my opinion, the quickest way for China to be thrown back into the economic dark ages is to signal to the markets that the rule of law does not apply in China. Free markets follow the guiding hand of Adam Smith, not the clenched fist of lawless totalitarianism and mob rule. No company in their right mind will move production to China if the rule of law is not respected, contracts are not enforced and their employees are not protected. Today in China an American CEO of a healthcare company is being held hostage by disgruntled employees upset that some Chinese jobs are being outsourced to India. The outsourcing of Chinese jobs to India is newsworthy by itself, but holding an American CEO hostage has the possibility of becoming a major international Black Swan scale disaster. One only needs to look at how single events during the Arab Spring toppled entire governments to understand how unpredictable these kinds of events are.

In conclusion, with a slowing economy, potential banking crisis, simmering civil unrest and now a possible international crisis the likelihood of a Black Swan event in China is greatly increasing. Add to the list that this will be China's first major financial/economic crisis of their modern politicoeconomic system and the odds increase further. The bottom line is that the risk of the Chinese economy has been greatly increased lately, and the way markets adjust for higher risk is by lowering their valuations. As the risks of the Chinese economy grow, I would expect their financial markets to continue lower, and would not be surprised to see a Black Swan event develop in the relatively near future. If anything happens to the American CEO, I would expect ramifications to be extremely deep and long lasting. Most companies, at least not publicly held companies, will be forced to avoid doing business with China, the risk will simply be too great, and unless the employees get hazard pay, no one will go there to work. China is at an inflection point, and how they handle this banking and CEO situation will likely determine how successful their path will be in the future. Lastly, a Chinese banking system crisis may have paradoxical affects on the markets. Safe haven investments like gold and US Treasuries may actually fall in value instead of benefiting from the crisis...at least in the early stages when it looks like it may be contained.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.