The bigger they are, the harder they fall. China is guilty of gross capital misallocation on the grandest scale in the history of the world. Never before in all of man's history have so many trillions (tens of trillions?) been blatantly wasted, in ways that will reverberate across the global economy for years to come.
Those whom the gods would destroy, they first rise up. This Brobdingnagian waste was made possible by the epic scale of the China miracle itself, and the fruits born of a sort of quasi-capitalism that, over decades of savings and legitimate growth, allowed for the marshaling of vast resources, combined with the worst excesses of command-and-control arrogance in the latter years.
Like the now defunct Enron, the China growth story was a one-time good thing ultimately gone bad - very, very bad. China's economy is, in short, potentially the biggest disaster-in-waiting the world has ever seen.
It has been a long time coming. The consequences will continue to unfold in slow motion. But that is often the case with such things. And repercussions from "The Great Fall of China" are increasingly being felt:
Some of the world's largest companies have sounded the alarm about the slowdown in the Chinese economy, warning that weaker growth would hit profits in the second half of the year.
Car companies such as PSA Peugeot Citroën, Audi and Ford have slashed growth forecasts while industrial goods groups such as Caterpillar and Siemens have all spoken out on the negative impact of China.
The warnings are a sign that China's weaker growth and its stock market rout this month are creating a headache for global corporates that have long relied heavily on the world's second-largest economy to drive revenues….
Many Western companies are rethinking their entire China strategy. Profit growth in China was already rocky and hard to come by, the competition often unfairly tilted toward local advantage (if not flat out corrupt). If that was a description of the China business landscape in the "good" times… then what happens when the wheels come off the wagon?
The Chinese slowdown is forcing many Western companies to take a hard look at their businesses there, leading many to reduce investments, costs and product lines and to tackle increasing bad debts.
Double digit growth rates during the first decade of the millennium lured scores of Western companies to invest heavily in China. But in recent years growth has slowed sharply, hitting demand and raising doubts about the financial health of Chinese companies.
A recent equities market rout has dashed hopes China will, in the coming years, return to the robust growth it saw in the past.
Meanwhile, as China's equity market repeatedly freezes and crashes - like some horrible install of Microsoft Windows gone wrong - Beijing is doing its best to flush its reputation for competence down the toilet (after setting it on fire).
After China's stocks crashed in June, the government put more than $400 billion at the disposal of a little-known state agency, the China Securities Finance Corp., headed by an academic and bureaucrat named Nie Qingping. It was told to save the market.
The agency's unique mandate is to intervene in the market to buy stocks, with money borrowed from the central bank and other sources, in order to help prop up share prices. With the recent volatility evidenced by another crash on July 27, its success so far isn't readily apparent…
In the midst of a public relations crisis, born of ham-fisted efforts gone horribly awry, the last thing you want to do is pour kerosene on the fire by making yourself look like a clueless panicky idiot.
And so, of course, Beijing continues to blame and chase "short sellers" - while shutting down outside investor access - in classic the panicky idiot style:
China is pressing foreign and Chinese-owned brokerages in Hong Kong and Singapore to hand over stock trading records, sources said, extending its pursuit of "malicious" short sellers of Chinese stocks to overseas jurisdictions…
Clear message to all foreign investors in China's equity markets: Beijing will blame you for its problems, and possibly screw you over without a moment's hesitation, if you choose to remain invested.
U.S.-based hedge fund firm Citadel LLC said trading in one of the accounts it manages in China has been suspended, as regulators battle a steep slide in stock prices.
China's securities regulator said Friday it has launched a probe into automated trading and has restricted 24 stock accounts suspected of influencing stock prices. The government didn't name any of the parties behind the restricted stock accounts. Citadel said Sunday that one of the accounts at a unit that helps clients buy and sell securities was among them.
Capital flows where it is treated best. As Paul Tudor Jones has said, the global economy is basically a flow chart for capital. So guess what happens when Beijing treats outside investor capital like dog crap?
China's foreign exchange reserves have dropped for four straight quarters, leading to a fresh round of warnings about capital outflows…
After hitting an all-time high of $3.99tn at the end of June 2014, reserves have fallen by $299bn. Analysts broadly agree that China has experienced capital outflows on an unprecedented scale. But they disagree about their size, causes, and the risk to the economy.
China is not run by geniuses. It is run by fools. And we are not Johnny-Come-Latelies to this view. We have been beating the drum for quite a long while now. And shame on Jim Rogers, and all the other macro bulls who were supposed to have known better, but chose to suspend rational economics (authoritarian top down economies don't work, for the same reason the Soviet Union didn't work) in favor of an investor's man crush on the Mandarins.
There is a lot of optimistic fluff and tralala about how China will weather this storm just fine and serious repercussions will be avoided. We think that is hopium (aka the wishful investor's opium). Where you stand depends upon where you sit, and the optimistic China view is peddled by those with deep, deep incentive to be naturally optimistic on China: Investment banks who want to do business in China… large institutional funds who want to manage China's wealth… giant mutual funds with deep long-only commitments to China… all of these guys have ten reasons to skew optimistic for every lone reason to be honest.
We are macro traders and, as such, we quite enjoy volatility. But on the whole we have no dog in this fight and no axe to grind with China. We simply strive to take an objective reading of the economics in the context of what we know about free market systems and financial market history - and we see pain. Incredible amounts of pain… in proportion to the gross excesses and insanely deep malinvestments that have long built up.
SSRN recently put out an excellent paper, by professors Christian Sorace and William Hurst, titled "China's Urbanization and The Pathology of Ghost Cities." You can access a copy of the paper in PDF format here.
This is harrowing stuff. We will share some excerpts and provide brief commentary:
Today the tragedy of the Great Leap forward is repeating as the comedy of the rapid capitalist Great Leap Forward into modernization, with the old slogan 'an iron foundry in every village' reemerging as 'a skyscraper on every street'…
The conventional wisdom regarding China's urbanization follows a standard narrative, combining assumptions regarding rural-to-urban migration, modernization, and development. As China attempts to transition from an export-driven economy to one based on domestic consumption, urbanization both absorbs investment and creates urban consumers, who tend to consume more than their rural counterparts. Even though China's property market is far from perfect, over-supply problems are seen as temporary, to be resolved as ever-more rural villagers migrate to China's cities.
The arrogant ignorance of Chairman Mao was beyond legendary. At one point Mao decided that sparrows were pests because they were eating China's grain. He did not investigate the logic of this assumption, he just assumed it, and ordered an anti-sparrow campaign in which hundreds of millions of rural Chinese were ordered to harass and kill and drive off sparrows and other small birds that were enemies of the state. They apparently did this with noisy pots and pans and by burning nests and cutting down trees and such. As it turned out, these sparrows were actually helping out the grain crops by controlling the insect population. With their numbers diminished, the insect population exploded. Guess what happened to the grain…
Just as bad was Mao's decision to have "an iron foundry in every village." He decided that all the populace should make iron, and the result was disaster… hugely wasted resources, great destruction of already meager economic wealth, and nobody willing to tell Mao how stupid the plan was or that all the iron being produced was so low grade quality as to be useless.
China, in other words, has a long history of wacky plans driven by top-down authoritarianism that sound fine on paper, but make no sense in actual practice. "A skyscraper on every street" is another such plan. Mao would have been proud…
China's miraculous urbanization story and future economic growth are one of those "remarkably resilient narratives" that rest on the magical formula 'if you build it, they will come.'
In China's scholarly, policy and popular discourses, however, a counter-narrative of "urban pathologies" tracks the problems caused by high-speed urban development, such as empty housing, population overcrowding, ecological destruction, and deteriorating infrastructures… Indeed, many Chinese scholars and policy analysts use neologisms like "fake urbanization"… "half urbanization"… "impetuous urbanization"… and urbanization yielding a "city without a city" [ literally, walls without a market]… to describe the phenomenon of building what resembles a city in name and morphology only.
China's urbanization - the ghost cities, the eight-lane highways, the 500,000 square foot shopping malls - are the product of a dream belief, "If you build it, they will come." This belief was propagated by Beijing, in the spirit of Mao, and reinforced and echoed by greed-oriented shills throughout the Western world (and those who chose to suspend rational assessment of how free market economic systems actually function).
The authors of the paper go on to note that, in typical patterns of developing world urbanization, the population comes first and the infrastructure follows. Millions of people find reason to cluster around a trade route, a market center, or a resource area of some kind - and the infrastructure of urbanization follows that. China has attempted to turn this completely on its head, which is akin to a government "deciding" to create a technology startup with a fifty-billion-dollar market cap value.
The story gets worse. China's urbanization boom has passed to the highest heights of gross excess because so many stakeholders involved have wanted, and needed, exactly this outcome:
…according to Citi, "in China, property is not only a type of consumption goods to satisfy housing needs, but also takes up a big responsibility to act as investment products. In the past 20 years, the China property market has acted as a huge capital reservoir" (Citi 2011, 31). Due to the extreme volatility of China's stock markets, legal restrictions on moving money overseas, low returns to bonds and other savings vehicles, and a frothy real estate market, Chinese investors often buy at least 3 different houses - either as short term investments they hope might rise in value and become wealth-generating or as stores for the long-term preservation of their existing wealth.
Because of this, any significant drop in Chinese housing prices threatens to wipe out truly massive amounts of private wealth: "in China real estate assets account for a dominant position due to the lack of investment alternatives. Some estimates put it at around 65% of personal wealth" (Citi 2011, 12) - as opposed to about 30-40% of US household wealth in real estate just prior to the 2008 collapse (Iacoviello 2011). The Citi report pessimistically suggests: "if property prices collapsed in the coming 1-2 years, it would have a significant impact on personal wealth of the public and result in severe deterioration in personal consumption" (Citi 2011, 12).
The local state also has an extraordinarily strong vested interest in maintaining urbanization and real estate's inflationary momentum. After the 1994 fiscal reforms, many localities across China faced dwindling revenues, coupled with rapidly growing budgetary expenditures and obligations. The central government began re-centralizing fiscal revenue streams, while simultaneously de-centralizing governance responsibilities - creating a crisis for local governments. By 2010, local governments were responsible for 82.2 % of fiscal expenditures, while the central state took in just over half of all 13 government revenue (DRCSC 2012, 6). In order to remedy the imbalance between increasing expenditures and shrinking funds, accentuated by restrictions on their collection of extra-budgetary fees and revenues imposed in the mid-2000s, local governments came to rely excessively on land-generated finances as a main revenue stream, especially where local tax bases were less developed. Urban governance and management has thus been transformed steadily into a form of "urban business management"… in which the state appropriates farm land at relatively low compensation prices, sells that land to developers for a much higher price, and gains access to additional revenue through taxing the process (DRCSC 2012, 7). Indeed, "local government's financial structure excessively depends on land revenue" (DRCSC 2012, 8) - in 2010, local governments' income from land-transfer fees was 2.911 Trillion RMB, equivalent to 71.7% of their general budget revenue…
As local governments, development companies and investors all work to keep housing prices rising, Chinese real estate offers an extremely low rental yield. Its value is dependent almost entirely on its asset price, not on its potential for income-generation…
Using more polite language, the authors basically confirm our long-held view that major aspects of China's economy are little more than a giant Ponzi scheme:
In this article, we have argued that the extreme example of "ghost cities" exposes deeper patterns of urbanization propelled by political imperatives and aesthetic norms, which follow logics different from those of population pressures or market rationalities. Political success is dramatized through the expansion of urban space as a conduit to modernity, which promises economic abundance. The phantom urbanization process is precariously held together by the assumption that the construction of urban landscapes will eventually result in urbanization by attracting financial investment and residents. Ghost cities are the material artifacts of an unsuccessful conjuring trick.
The thing about large-scale macro crisis is the uncanny adherence to Dornbusch's law: "The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought."
Consider what's happening in China these days… and be prepared for the entire world to feel it. The "Great Fall" has only just begun…
Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.